Publication 908
Bankruptcy Tax Guide

Payment of Tax Claim

After the filing of a bankruptcy petition andduring the period the debtor's assets or those ofthe bankruptcy estate are under the jurisdictionof the bankruptcy court, these assets are notsubject to levy. TheInternal Revenue Service may file a proof ofclaim in the bankruptcy court the same way asother creditors. This claim maybe presented to the bankruptcy court even thoughthe taxes have not yet been assessed or aresubject to a Tax Court proceeding. 11 USC 362(a)(6); IRC 6213(f)(2);IRC 6871(c)(1)

Eighth priority taxes.   In bankruptcy, the debtor'sdebts are assigned priorities for payment. Most ofthe prepetition tax debts are classified aseighth priority claims.Generally, prepetition taxes arecertain income and other taxes that the debtor isconsidered to owe before he or she files abankruptcy petition.

The following federal taxes, if unsecured, areprepetition eighth priority taxes of thegovernment: 11 USC 502(f) and (i); U.S. Dept. ofJustice

1. Income taxes for tax years ending on orbefore the date of filing the bankruptcypetition, for which a return is due(including extensions) within 3 yearsof the filing of the bankruptcy petition. 11 USC 507(a)(7)(A)(i)
2. Income taxes assessed within 240 daysbefore the date of filing the petition. This240-day period is increased by any time, plus30 days, during which an offer in compromisewith respect to these taxes was pending, thatwas made within 240 days after theassessment. 11 USC 507(a)(7)(A)(ii)
3. Income taxes that were not assessed before thepetition date, but were assessable as of thepetition date, unless these taxes were stillassessable solely because no return, alate return (within 2 years of the filing of thebankruptcy petition), or a fraudulent returnwas filed. 11 USC 507(a)(7)(A)(iii)
4. Withholding taxes for which you are liable inany capacity. 11 USC 507(a)(7)(C)
5. Employer's share of employment taxes onwages, salaries, or commissions (includingvacation, 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 ofthe filing of the bankruptcypetition, including a return for which anextension of the filing date was obtained. 11 USC 507(a)(7)(D)
6. Excise taxes on transactions occurring beforethe date of filing the bankruptcy petition, forwhich a return, if required, is due(including extensions) within 3 yearsof the filing of the bankruptcy petition. If areturn is not required, these excise taxesinclude onlythose on transactions occurring during the3 years immediately before the date offiling the petition. 11 USC 507(a)(7)(E)

Priority of payment.   For a chapter 7 case, the preceding eighthpriority prepetition taxes may be paid out ofthe assets of the bankruptcy estate to the extentthere are assets remaining after paying theclaims of secured creditors and other creditorshaving higher priority claims.

Different rules apply to payment of eighthpriority prepetition taxes under chapters 11,12, and 13:

1. In chapter 11, the debtor can pay these taxesover a period of 6 years from the date ofassessment, including interest,
2. In chapter 12, the debtor can pay suchtax claims in deferred cash payments over time,and
3. In chapter 13, the debtor can pay such taxesover 3 years (or over 5 years with courtapproval).

11 USC 506; 507; DOJ Ltr 7/7/94

Certain taxes are assigned a higher priorityfor payment. Taxes incurred during administrationby the bankruptcy estate are paid first, asadministrative expenses.Taxes arising in the ordinary courseof your business or financial affairs in aninvoluntary bankruptcy case, after thefiling of the bankruptcy petition but before theearlier of the appointment of a trustee or theorder for relief are included in thesecond priority of payment. The employee'sportion of the employment taxes on the first$4,000 (to be adjusted 4/1/98) described in (5)above is included in the third priority. 11 USC 503(b)(1)(B), 507(a)(1), (2), and (6),541, 523, 502, 501, 362, 104

Relief from penalties.   A penalty for failure topay tax, including failure to pay estimated tax,will not be imposed for any period duringwhich a title 11 bankruptcy case is pending, underthe following conditions. If the tax was incurredby the bankruptcy estate, the penalty will not beimposed if the failure to pay resulted from anorder of the court finding probable insufficiencyof funds of the estate to pay administrativeexpenses. If the tax was incurred by you as thedebtor, the penalty will not be imposed if:

1. The tax was incurred before the earlier of theorder for relief or (in an involuntary case) theappointment of a trustee, and
2. The bankruptcy petition was filedbefore the due date for the tax return (includingextensions) orthe date for imposing the penalty occurs on orafter the day the bankruptcy petition was filed.

IRC 6658(a)(2)

This relief from the failure-to-pay penaltydoes not apply to any penalty for failure to payor deposit tax withheld or collected from othersand required to be paid over to the U.S.government. Nor does it apply to any penalty forfailure to timely file a return. IRC 6658(b)

FUTA credit.   An employer isgenerally allowed a credit against the federalunemployment tax (FUTA) for contributionsmade to a state unemployment fund, if thecontributions are paid by the last day for filingan unemployment tax return for the tax year. Ifthe contributions to the state fund are paid afterthat date, generally only 90% of the otherwiseallowable credit may be taken against the federalunemployment tax. IRC 3302(a)(1) and (3)

However, for any unemployment tax on wagespaid by the trustee of a title 11 bankruptcyestate, if the failure to pay the stateunemployment contributions on time was withoutfault by the trustee, the full amount of thecredit is allowed. IRC 3302(a)(5)

Statute of limitations for collection.   In a title 11 bankruptcy case, the period oflimitations for collection of tax (generally, 10years after assessment) is suspended for theperiod during which the Internal Revenue Serviceis prohibited from collecting, plus6 months thereafter. IRC 6502(a); IRC 6503(h)

Discharge of Unpaid Tax

Debts are dividedinto two categories; dischargeable and nondischargeable. Dischargeable debts are thosethat the debtor is no longer personally liableto pay after thebankruptcy proceedings are concluded. Nondischargeable debts are those that are notcanceled because of the bankruptcy proceedings.The debtor remains personally liable for theirpayment.

As a general rule, there is nodischarge for you as an individual debt or at the termination of a bankruptcy case forthe second and eighth priority taxes described earlier, or for taxesfor which no return, a late return (filed within 2 years of the filing of the bankruptcypetition), or a fraudulent return was filed.However, claims against you for othertaxes 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. 11 USC 523(a)(1); IRC 6873

Exception for individuals with regular income.   If you complete all payments under a chapter 13 debt adjustment plan for an individual withregular income, the court may grant you adischarge of debts, including adischarge of the second and eighth priority prepetition taxes described earlier. However, ifyou fail to complete all payments under the plan, these taxes are not discharged although the court may grant a discharge of other debts in limited circumstances. 11 USC 1328(a), (b), and (c); Admin. Office of theU.S. Courts

Debt Cancellation

If a debt is canceled or forgiven, other than as a gift or bequest,the debtor generally must include the canceledamount in gross income for tax purposes. A debt includes any indebtedness for which the debtor is liable or which attaches to property the debtorholds. IRC 108(d)(1); IRC 108(e)(1);IRC 61(a)(12)

Exceptions and Exclusions

There are several exceptions and exclusionsfrom the inclusion of canceled debt in income.The exceptions include:

1. The cancellation of a student loan for astudent required to work for certain employers.See Cancellation of student loan inPublication 525, Taxable andNontaxable Income.
2. The cancellation of debt that would have beendeductible if paid. IRC 108(e)(2)
3. The reduction of a debt by the seller ofproperty if the debt arose from the purchase ofthe property. IRC 108(e)(5)

The exclusions are discussed next.

Exclusions

Do not include a canceled debtin gross income if any of the following situationsapply:

• The cancellation takes place in a bankruptcycase under the U.S. Bankruptcy Code.See Bankruptcy caseexclusion, later.
• The cancellation takes place when you areinsolvent(see Insolvency exclusion, later),and theamount excluded is not more than the amountby which you are insolvent.
• The canceled debt isqualified farm debt (debt incurred inoperating a farm). See chapter 4 of Publication225, Farmer's Tax Guide.
• The canceled debt is qualified real propertybusiness indebtedness (certain debt connectedwith business real property). See Publication 525,Taxable and Nontaxable Income.

IRC 108(a)(1)

Order of exclusions.   If the cancellation of debt occurs in atitle 11 bankruptcy case, the bankruptcy exclusiontakes precedence over the insolvency, qualifiedfarm debt, or qualified real property businessindebtedness exclusions. IRC 108(a)(2)(A)

To the extent that the taxpayeris insolvent, the insolvency exclusion takesprecedenceover qualified farm debt or qualified realproperty business indebtedness exclusions. IRC 108(a)(2)(B)

Bankruptcy case exclusion.   A bankruptcy case is a case under title 11 ofthe United States Code, but only if the debtoris under the jurisdiction of the court and thecancellation of the debt is granted by the courtor occurs as a result of a plan approved by thecourt. IRC 108(d)(2)

None of the debt canceled in a bankruptcycase is included in your gross income in the yearcanceled. Instead, certain losses, credits, andbasis of property must be reduced by theamount of excluded income (but not belowzero).These losses, credits, and basis in propertyare called tax attributes and are discussedunder Reduction of TaxAttributes, later. IRC 108(a)(1)(A); IRC 108(b)(1);IRC 108(b)(5)

Insolvency exclusion.   You are insolvent when,and to the extent, your liabilities exceed thefair market value of your assets.Determine your liabilities and thefair market value of your assets immediatelybefore the cancellation of your debt to determinewhether or not you are insolvent and the amount bywhich you are insolvent. IRC 108(d)(3)

Exclude from your gross income debtcanceled when you are insolvent, but only up tothe amount by which you are insolvent. However,you must use the amount excluded toreduce certain tax attributes, as explained laterunder Reductionof Tax Attributes. IRC 108(a)(3); IRC 108(b)(1);IRC 108(b)(5) Example.

$4,000 of the Simpson Corporation'sliabilities are cancelled outside bankruptcy.Immediately before the cancellation, the SimpsonCorporation's liabilities totaled $21,000 and thefair 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 becausethat is the amount by which it was insolvent.It must also reduce certain tax attributes by the$3,500 of excluded income. Theremaining $500 of canceled debt must beincluded in income.

Reduction of Tax Attributes

If a debtor excludes canceled debt from incomebecause it is canceled in a bankruptcy case orduring insolvency, he or shemust use the excluded amount to reducecertain tax attributes. Tax attributesinclude the basis of certain assets andthe losses and credits listed next.By reducing these taxattributes, tax on the canceled debt is in partpostponed instead of being entirely forgiven. Thisprevents an excessive tax benefit from the debtcancellation.

If a separate bankruptcy estate was created,the trustee or debtor-in-possession must reducethe estate's attributes (but not below zero) bythe canceled debt. See Individuals underchapter 7 or chapter 11, later. IRC 108(b)(1); IRC 108(g)

Order of reduction.   Generally, use theamount of canceled debt to reduce the taxattributes in the order listed below. However, youmay choose to use all or a part of the amount ofcanceled debt to first reduce the basis ofdepreciable property before reducing the other taxattributes. This choice is discussedlater. IRC 108(b)(2)(A) and IRC 108(b)(5)(A)

Net operating loss.   First, reduce any netoperating loss for the tax year in which the debtcancellation takes place, and any net operatingloss carryover to that tax year. IRC 108(b)(2)(A)

General business credit carryovers.   Second, reduce any carryovers, to or from thetax year of the debt cancellation, of amounts usedto determine the general business credit. IRC 108(b)(2)(B)

Minimum tax credit.   Third, reduce any minimum tax creditthat is available as of the beginning of the taxyear following the tax year of the debtcancellation. IRC 108(b)(2)(C)

Capital losses.   Fourth, reduce any net capitalloss for the tax year of the debt cancellation,and any capital loss carryover to that year. IRC 108(b)(2)(D)

Basis.   Fifth, reduce the basis of yourproperty as describedunder Basis Reduction, later.This reduction applies to the basis of bothdepreciable and nondepreciable property. IRC 108(b)(2)(E)

Passive activity loss and credit carryovers.   Sixth, reduce any passive activity loss orcredit carryover from the tax year of the debtcancellation. IRC 108(b)(2)(F)

Foreign tax credit.   Last, reduce anycarryover, to or from the tax year of the debtcancellation, of an amount used to determine theforeign tax credit or the Puerto Rico andpossession tax credit. IRC 108(b)(2)(G) and IRC 27

Amount of reduction.   Except for the creditcarryovers, reduce the tax attributes listedearlier one dollar for each dollar of canceleddebt that is excluded from income. Reduce thecredit carryovers by 33'1'D='3'/'3' cents foreach dollar of canceled debt that is excludedfrom income. IRC 108(b)(3)

Making the reduction.   Make the requiredreductions in tax attributes after figuring thetax for the tax year of the debt cancellation. Inreducing net operating losses and capital losses,first reduce the loss for the tax year of the debtcancellation, and then any loss carryovers to thatyear in the order of the tax years from which thecarryovers arose, starting with the earliest year.Make the reductions of credit carryovers in theorder in which the carryovers are taken intoaccount for the tax year of the debt cancellation. IRC 108(b)(4)

Individuals under chapter 7 or chapter 11.   In an individual bankruptcy under chapter 7(liquidation) or chapter 11 (reorganization) oftitle 11, the requiredreduction of tax attributes must be made to theattributes of the bankruptcy estate, aseparate taxable entity resulting from the filing ofthe case. Also, the trustee of thebankruptcy estate must make the choice ofwhether to reduce the basis of depreciable propertyfirst before reducing other tax attributes.See the discussionof The BankruptcyEstate, earlier. IRC 108(d)(7)

Basis Reduction

If any amount of the debt cancellation is usedto reduce the basis of assets as discussedunder Reduction of TaxAttributes, thefollowing rules apply to the extent indicated. IRC 108(b)(2)(D) and IRC 1017(a)

When to make the basis reduction.   Makethe reduction in basis at the beginning of the taxyear following the tax year of the debtcancellation. The reduction applies to propertyheld at that time. See section 1.1017-1of the Income Tax Regulations for more information. IRC 1017(a)

Bankruptcy and insolvency reduction limit.   The reduction in basis because of canceled debtin bankruptcy or in insolvency cannot be morethan the total basis of property heldimmediately after the debt cancellation, minusthe total liabilities immediately after thecancellation. This limit does not apply if anelection is made to reduce basis before reducingother attributes. This election is discussedlater. IRC 1017(b)(2)

Exempt property under title 11.   If debt is canceled ina bankruptcy case under title 11 of the UnitedStates Code, make no reduction in basis forproperty that the debtor treats as exempt propertyunder section 522 of title 11. IRC 108(d)(10); IRC 1017(c)(1)

Election to reduce basis first.   You (the estate in the case of an individualbankruptcy under chapter 7 or 11) maychoose to reduce the basis of depreciableproperty before reducing any other taxattributes. However, thisreduction of the basis of depreciable propertycannot be more than the total basis of depreciableproperty held at the beginning of the taxyear following the tax year of the debtcancellation. IRC 108(b)(5)

Depreciable property meansany property subject to depreciation, but only ifa reduction of basis will reduce the amount ofdepreciation or amortization otherwise allowablefor the period immediately following the basisreduction. You may choose totreat as depreciable property anyreal property that is stock in trade or is heldprimarily for sale to customers in the ordinarycourse of trade or business. You must generallymake this choice on the tax return for the taxyear of the debt cancellation, and, once made,you can only revoke it with IRS approval. However,if you establish reasonable cause, you may makethe choice with an amended return or claim forrefund or credit. IRC 1017(b)(3)

Making elections.   Make the election toreduce the basis of depreciable property beforereducing other tax attributes as well as theelection to treat real property inventory asdepreciable property, on Form 982,Reduction of Tax Attributes Due toDischarge of Indebtedness (and Section 1082 BasisAdjustment). Reg. 7a.1(d)(1)

Recapture of basis reductions.   If any basis in propertyis reduced under theseprovisions and is later sold or otherwise disposedof at a gain, the part of the gain that isfrom this basis reduction is taxable asordinary income. Figure the ordinary income partby treating the amount of this basis reduction as adepreciation deduction and by treating any suchbasis-reduced property that is not already eithersection 1245 or section 1250 property assection 1245 property. In the case ofsection 1250 property, make thedetermination of what would have been straightline depreciation as though there had been nobasis reduction for debt cancellation.Sections 1245 and 1250 and the recapture ofgain as ordinary income are explainedin chapter 4, Dispositions of DepreciableProperty, inPublication 544, Sales and OtherDispositions of Assets. IRC 1017(d)

Partnerships

If a partnership's debt is canceled becauseof bankruptcy or insolvency, the rules for theexclusion of the canceled amount from gross incomeand for tax attribute reduction are applied at theindividual partner level. Thus, each partner'sshare of debt cancellation income must be reportedon the partner's return unless the partner meetsthe bankruptcy or insolvency exclusions explainedearlier. Then all choices, such as the choices toreduce the basis of depreciable property beforereducing other tax attributes, to treat realproperty inventory as depreciable property,and to end the tax year on the day before filingthe bankruptcy case, must be made by theindividual partners, not the partnership. IRC 108(d)(6); IRC 703(b)(2);IRC 1398(b)(2)

Depreciable property.   For purposes of reducingthe basis of depreciable property in attributereduction, a partner treats his or her partnershipinterest as depreciable property to the extent ofthe partner's proportionate interest in thepartnership's depreciable property. This appliesonly if the partnership makes a correspondingreduction in the partnership's basis in itsdepreciable property with respect to the partner. IRC 1017(b)(3)(C)

Partner's basis in partnership.   The allocationof an amount of debt cancellation income to apartner results in that partner's basis in thepartnership being increased by that amount. At thesame time, the reduction in the partner's share ofpartnership liabilities caused by the debtcancellation results in a deemed distribution, inturn resulting in a reduction of the partner'sbasis in the partnership. These basis adjustmentsare separate fromany basis reduction under theattribute-reduction rules describedearlier. Sen.Rep. 96-1035

Corporations

Corporations in a bankruptcy proceeding orinsolvency generally follow the same rules fordebt cancellation and reduction of tax attributesas an individual or individual bankruptcy estatewould follow.

Stock for Debt Exchange

If a corporation transfers its stock insatisfactionof indebtedness and the fair market value of itsstock is less than the indebtedness it owes, thecorporation has income (to the extent of thedifference) from the cancellation of indebtedness.After 1994, a corporation can excludeall or a portion of the income created by thestock for debt transfer if it is in a bankruptcyproceeding or, if not in a bankruptcy proceeding,it can exclude the income to the extent it isinsolvent. However, thecorporation must reduce itstax attributes (to the extent it has any) by theamount of excluded income.

Stock for debt exception.   The stock for debt exception was repealedfor transfersmade after 1994 unless the corporation filed forbankruptcy (or similar court proceeding) before 1994.Generally, before1995, a corporation did not realize incomebecause of such stock for debt exchanges if it wasin bankruptcy or to the extent it was insolvent.Consequently, there was no gross income to excludeand no reduction of its tax attributes wasnecessary. The principal differencebetween the stock for debt exception and the stockfor debt exchange is that the corporation does notreduce its tax attributes under the stock for debtexception. IRC 108(e)(10)

Earnings and profits

The earnings and profits of a corporation donot include income from the discharge ofindebtedness to the extent of the amount appliedto reduce the basis of the corporation's propertyas explainedearlier. Otherwise,discharge of indebtedness income, includingamounts excluded from gross income, increasesthe earnings and profits of the corporation (orreduces a deficit in earnings and profits). IRC 312(l)(1); Sen Rep 96-1035

If there is a deficit in the corporation'searnings and profits and the interest of anyshareholder of the corporation is terminated orextinguished in a title 11 or similar case(defined earlier), the deficit must be reducedby an amount equal to the paid-in capitalallocable to the shareholder's terminated orextinguished interest. IRC 312(l)

S Corporations

For S corporations, the rules for excludingincome from debt cancellation because ofbankruptcy or insolvency apply at the corporatelevel.

Net operating losses.   A loss or deduction that is disallowed forthe tax year of the debt cancellation because itexceeds the shareholders' basis in thecorporation's stock and debt is treated as a netoperating loss for that tax year in making therequired reduction of tax attributes for theamount of the canceled debt. IRC 108(d)(7)(A&B); IRC 1366(d)

Tax Attribute Reduction

Example

The sample filled-in Form982, Reductionof Tax Attributes Due to Discharge ofIndebtedness (and Section 1082 BasisAdjustment), shown in this publicationis based on the following situation.

Tom Smith is in financial difficulty, but hehas been able to avoid declaring bankruptcy. In1995, he reached an agreement with his creditors,whereby they agreed to forgive $10,000 of thetotal that he owed them, in return for his settingup a schedule for repayment of the rest of hisdebts.

Immediately before the debt cancellation,Tom's liabilities totaled $120,000 and the fairmarket value of his assets was $100,000 (his totalbasis in all these assets was $90,000). At thetime of the debt cancellation, he was consideredinsolvent by $20,000. He can exclude from incomethe entire $10,000 debt cancellation because itwas not more than the amount by which he wasinsolvent.

Among Tom's assets, the only depreciableasset is a rental condominium with an adjustedbasis of $50,000. Of this, $10,000 is allocable tothe land, leaving a depreciable basis of $40,000.He has a long-term capital loss carryover to 1996of $5,000.He also has a net operating lossof $2,000 and a $3,000net operating loss carryover from 1994.He has no other tax attributesarising from the current tax yearor carried to this year.

Ordinarily, in applying the $10,000 debtcancellation amount to reduce tax attributes, Tomwould first reduce his $2,000net operating loss, next his $3,000 net operatingloss carryover from 1994, andthen his $5,000 net capitalloss carryover. However, he figures that it is betterfor him to preserve his loss carryovers for the nexttax year.

Tom elects to reduce basis first.He can reduce the depreciable basis of his rentalcondominium (his only depreciable asset) by$10,000. The tax effect of doing this will be toreduce his depreciation deductions for yearsfollowing the year of the debt cancellation.However, if he later sells the condominium at again, the part of the gain from thebasis reduction will be taxable as ordinaryincome.

Tom must file Form 982, as shownhere, with his individual return (Form 1040)for the tax year of the debt discharge. Inaddition, he must attach a statement describingthe debt cancellation transaction and identifyingthe property to which the basis reduction applies.This statement is not illustrated. Form 982 for Tom Smith

How to Get More Information

You can get help from the IRS in several ways.

Free publications and forms.   To order free publications and forms, call 1-800-TAX-FORM (1-800-829-3676).You can also write to the IRS Forms Distribution Center nearest you. Check your income tax packagefor the address. Your local library or post office also may have the items you need.

For a list of free tax publications, order Publication 910, Guide to Free Tax services.It also contains an index of tax topics and related publications and describes other free tax information services available from IRS, including tax education and assistance programs.

If you have access to a personal computer andmodem, you also can get many forms and publications electronically. See How To Get Forms andPublications in your income tax package for details. If space permitted, this information is at the end of this publication.

Tax questions.   You can call the IRS with your tax questions.Check your income tax package or telephone book for the local number, or you can call 1-800-829-1040.

Telephone help for hearing-impairedpersons.   If you have access to TDD equipment, you can call 1-800-829-4059 to ask tax questions or to order forms and publications. See your income tax package for the hours ofoperation.