My last post hit some highlights on tax debt from a presentation by Professor Williams at the 16th Biennial Judge Joe Lee Bankruptcy Institute. This post delves a bit deeper into a specific tax law I touched on in that last post. The tax code provision is 26 USC Sect 1398 and it applies specifically to Chapter 7 and Chapter 11 bankruptcy cases. It does not address Chapter 13 cases.
The main thrust of Sect. 1398 is to allow for a Debtor to make an election to treat their ordinary tax year as two separate, shorter tax years. The first tax year would go up to and include the day before a Chapter 7 or Chapter 11 is filed. The second tax year includes the filing date of the bankruptcy and runs through the remainder of the normal tax year. This does NOT happen automatically, so the Debtor must take affirmative action.
If a married couple file jointly, the Joint-Debtor may also make this same election, but again it has to be an affirmative step taken by the Joint-Debtor; the Debtor’s election does not automatically apply to the Joint-Debtor. The election of the Debtor and election of the Joint-Debtor must be made no later than the due date for filing the return for the first short year and it cannot be undone once made.
By making the election, income that is part of the bankruptcy estate is taxable to the estate instead of to the Debtor. An example of how this might matter for a consumer debtor is if the Debtor becomes entitled to an inheritance or lottery winnings during the 180 days after filing. These monies get pulled back into the estate and might not be exempt or only partially exempt. Without this election, the Debtor may be hit with taxes on monies they were not able to keep.
This tax code provision would most usually come into play for business related bankruptcy debtors. Even if the Debtor is an individual, they own a business entity that may not be exempt or only partially exempt. The revenue that business generates would be income to the estate to the extent that business entity is not exempt. This can occur through ongoing revenues of the business or liquidation. The Debtor, again, would not want to be liable for taxes on funds they cannot enjoy.
The 1398 provision does not, however, have any impact on tax debt arising prior to the filing of the bankruptcy and the vast majority of consumer debtors will never need to avail themselves of this election to split tax years. Business related debtors need to be mindful of this option when there are non-exempt assets. Businesses entering bankruptcy as an entity, rather than the individual owner, must remember this election.
One of my repeated themes is to seek legal counsel early. This is a variation on the theme of seeking counsel when trouble first rears it head so that you can plan for the worst case eventuality. This post is geared towards those entrepreneurial spirits out there who are forging ahead with starting their own businesses. It takes an extra measure of courage to do this in this post-recession recovery period (I am not entirely convinced that we are post-recession, but let’s go with it). And, along with that extra measure of courage I recommend an extra measure of counsel.
For by wise guidance you will wage war, And in abundance of counselors there is victory. Proverbs 24:6 (NASB)
And, while starting a business is not as bloody as waging war, it is indeed a financial battle. So, I recommend getting counsel from a lawyer all the way from setting up the proper corporate entity to tips on financing that can save you down the road. While talking to a lawyer about your business idea may not be the most inspiring and motivating conversation, it can be a lifesaver for you finances. This is because lawyers are trained to think about and plan for worst case scenarios – those eventualities you do not want to contemplate. The conversation, then, may feel like it is taking wind from your sails. However, making sure the right documents are in place from the inception of your business all the way to how to sign on promissory notes can make a huge difference when times are tough.
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- When Business Owners Should File Bankruptcy
- To File or Not to File: Attorney decision making
- Deadlines for Filing Prepetition Tax Returns in Chapter 13 Cases
- Delinquent Property Tax Claims in Chapter 13 Cases
- Lessons Learned the Hard Way
- Miscellaneous Hot Topics in the EDKY
- ‘Tis the Season
- How to Choose a Bankruptcy Lawyer
- The Entrepreneurship – Bankruptcy Intersection
- Making Chapter 13 Plan Payments in the E.D. Ky. – New Online Payment Option
- “I’ve Changed My Mind – I Want to Surrender My House”: What Effect Does Post-Confirmation Surrender Have on the Debtor’s Discharge?
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