Introduction

In his presentation, Jeff Wong addressed the analysis necessary to identify the income tax consequences which may arise in bankruptcy situations when a taxpayer receives a cancellation of its indebtedness in exchange for property.  As he demonstrated, that analysis can be quite complicated.  And some of the tax consequences, particularly those arising from the treatment of non-recourse debt cancellation mandated by the Supreme Court's decision in Tufts, can sometimes be quite surprising.

In his introductory remarks, Jeff pointed out the complexity of debt cancellation tax issues, when combined with bankrupt taxpayers' predictably poor records and tax professionals' unfamiliarity with bankruptcy procedure, frequently results in significant errors in the tax treatment of those transactions.

I would suggest that tax analysis and reporting problems with bankruptcy-related transactions run even deeper.  Many tax professionals are also unfamiliar with the various Internal Revenue Code (IRC) provisions directed at insolvent debtors, since those provisions seldom affect recurring paying clients' tax computations.  Furthermore, the peculiar legal and economic relationships among bankruptcy proceeding participants often result in transactions with relatively little tax treatment precedent.

And the normal bankruptcy tax analysis and reporting problems seem to be compounded when separate legal entities which pass some or all of the tax effects of their transactions through to their owners ("flow-through entities") are involved in the proceedings.  What can otherwise be thought of as a three part inquiry (that is, the amounts of the taxpayer's taxable income, if any, and of any resulting tax, and when that tax becomes payable) often becomes a multi-dimensional quagmire.

In each proposed transaction involving flow-through entities, the IRC and related authority may create multiple potential taxpayers, each with a different set of qualification, income and tax computation rules, and each with potentially different year-end and measurement dates.  And the IRC may not even represent the controlling law on all bankruptcy tax issues; provisions of the Bankruptcy Code or even the entities' state enabling statutes may instead control certain tax determinations.

These materials are intended to do nothing more than identify some of the major income tax rules and issues related to the more common types of flow-through entities encountered in bankruptcy situations, and to suggest some potential resulting traps and opportunities.  In particular, these materials focus on entities classified either as partnerships under IRC Subchapter K or as S corporations under IRC Subchapter S, although there is sporadic mention of some rules related to entities classified as trusts or estates under IRC Subchapter J.

Flow-Through Entity Status
  
The principal attraction of flow-through entity treatment arises from the brief assertion of IRC sec. 11(a) that "A tax is hereby imposed for each taxable year on the taxable income of every corporation."  That IRC section effectively subjects the earnings of a non-flow-through business entity to a second level of taxation before those earnings reach the entity's owners.

Owners of entities eligible for taxation as S corporations and of some entities eligible for taxation as partnerships, including limited liability companies (LLC') and some limited liability partnerships, are also permitted the protection of a corporate-type shield for liability purposes under every state's law.  The combination of a single level of income tax and limited individual liability for entity debts has made these pass-through entities the vehicles of choice for most well-advised closely-held businesses.

The single level of income tax available to S corporations and LLC's, however, is at the owner level, rather than at the entity level; the income is not taxed to the legal entity which actually earns it.  Perhaps not surprisingly, therefore, taxation under both Subchapter K and Subchapter S is elective.  Subject to certain restrictions and to possibly unfavorable immediate tax consequences from the election, the IRC permits owners to elect eligible entities into, and to terminate entities out of, taxation as an S corporation or a partnership.

Normally, no parties to bankruptcy proceedings object to the use of beneficial elections available under the IRC.  If a debtor's income tax liability can be minimized, this preserves a larger portion of the estate for the benefit of creditors.  Some recent attempted uses of the S corporation election and termination rules have created a major ongoing dispute in the bankruptcy context, however, because the objective was a shift of tax liability away from owners and to their bankrupt entity, rather than just a decrease in the overall tax liability.

Absent special circumstances, the owners of corporations are not liable for the tax imposed on corporations by IRC sec.11. Thus, effective termination of a bankrupt corporation's S election prior to generation of corporate income shifts taxation of that income to the corporation itself, with no recourse against shareholders.  Normally, corporate owners would not take that step lightly, because subsequent distributions of the remaining income would be taxable a second time, to them.  When subsequent distributions will go to other parties, however, the double tax restraint is much less effective.

The decided cases, including one by the Ninth Circuit Bankruptcy Panel, have so far unanimously found S corporation status to be a form of property right, and any attempted S election termination to be a potential fraudulent transfer of that right.  See, e.g., Matter of Inter Urban Broadcasting of Cincinnati, Inc., 180 B.R. 153 ( Bankr. E.D. La, 1995); In re River City Hotel Corp., 75 AFTR 2d 2759 ( Bankr. E.D. Tenn, 1995); In re Trans-Lines West, Inc., 203 B.R. 653 (Bankr. E.D. Tenn., 1996); In re Bakersfield Westar, Inc., 226 B.R. 227 (Bankr. CA-9, 1998).

There does not yet seem to be any similar reported litigation concerning entities taxed either as partnerships or as disregarded LLC's.  Once practitioners recognize the flexibility of the election and termination opportunities provided by the "Check the Box" regulations at Treas. Reg. sec. 301.7701-3, however, there probably soon will be.

Recent commentators have presented persuasive arguments that the existing S corporation election cases were wrongly decided.  See, e.g., Galesi, "Shareholder's Rights Regarding Termination of a Debtor Corporation's S Status in a Bankruptcy Setting", 10 J. Bankr. L and P 157 (2001); Shaw, "S Corporation Election Risks in Bankruptcy", 60 N.Y.U. Institute on Federal Taxation 20-1 (2002).

When and whether flow-through elections can be terminated is of major significance in any bankruptcy tax analysis where such entities are involved.  It would be useful to identify the appropriate rule.  As this author understands it, however, the reported decisions provide no binding precedent ; even the Bankruptcy Appellate Panel decision is not considered precedential (Bank of Maui v. Estate Analysis, Inc., 904 F.2d 470 (9th Cir. 1990).  The Bakersfield Westar decision, however, suggests that the odds may favor eventual Ninth Circuit adoption of the fraudulent transfer position.

If the decisions in the flow-through election termination decisions do not finally resolve that issue, however, the issues which were considered, or should have been, in reaching those decisions provide an excellent platform for these materials.  Not a platform from which to dive into the swamp, mind you, or even to enter it at all; more of a viewing platform...

Flow-Through Entities As Sources of Taxable Income

In the reported flow-through entity termination decisions, the entity itself is the debtor, and the dispute is primarily over whether an existing flow-through entity election is property of the entity itself.  In evaluating that issue, the decisions focus on the fact that the entity is a potential source of taxable income, gains or losses from its own operations.  Any such income, gains or losses are clearly reportable both on the entity's own returns and on the returns of their owners during bankruptcy proceedings.  The asserted property right is the requirement that the resulting tax be paid by the owners on the entity's behalf.

A bankruptcy filing by itself has very limited impact on the computation of a business entity's taxable income from operations.  As pointed out above, and much more thoroughly in Jeff's presentation, some transactions which frequently appear in bankruptcy situations have may have unexpected tax results, but most computational surprises are not normally different for flow-though entities.  Nevertheless, some observations on flow-through entity taxable income computations seem appropriate.

First, there is a possibility of abnormal tax treatment of some flow-through entity transactions. And a likely source of such items is those receipts and disbursements subject to Bankruptcy Court discretion or other restrictions under the Bankruptcy Code.  Administrative expenses incurred during a bankruptcy proceeding may provide an example.  As a general rule, the deductibility of expenses for tax purposes requires the existence of a liability.  Arguably, the Bankruptcy Court's discretion to disapprove even previously-paid amounts through the termination of the proceeding prevents deduction of such expenses prior to that time.

In addition, the frequency, magnitude and potentially undesirable tax consequences of some types of transactions encountered by many business entity debtors in bankruptcy seem to require at least mention of the applicable rules, even though those rules probably apply equally outside of the bankruptcy arena.

Again, some administrative expenses may represent an example.
 
In the introduction to his discussion of the potential tax consequences of the most common types of transactions involving the cancellation of secured indebtedness, Jeff defined gain for income tax purposes as the excess of the amount realized upon disposition of property over its adjusted basis.  He pointed out that the adjusted basis of property for this purpose should be the property's initial basis after allowed or allowable depreciation deductions.

Jeff further explained that, in the secured debt cancellation context, the amount deemed realized in a property disposition normally depends, among other things, upon the amount of debt, the value of the property, and the recourse or non-recourse nature of the debt. He contrasted the  bifurcation of recourse debt cancellation between sale proceeds to the extent of property fair market value and cancellation of indebtedness income (COD) beyond that amount, and the Supreme Court mandated treatment of the full amount of cancelled non-recourse debt as sale proceeds based upon the Tufts decision.

Jeff left it to me to point out that the effect of the Tufts decision is sometimes avoidable.  If for example, a creditor reduces non-recourse debt to the value of the secured property in an attempt to assist a workout, without taking the property itself, Cod rather than sale proceeds results from the debt cancellation.  Additionally, the Internal Revenue Service has taken the position that the Bankruptcy Code provisions which convert undersecured non-recourse debt to unsecured debt shift a subsequent cancellation of the converted amount from sale proceeds to COD.

In the interest of simplicity, Jeff also left it unsaid that there are major areas of uncertainty in the definition of nearly all of the terms employed in describing the calculation of tax gain or gloss in debt cancellation situations.  Valuation of property which secures debt is as much an art as a science.  It is sometimes unclear whether debt is properly characterized as recourse or non-recourse.  In fact, it is sometimes difficult to determine whether a potential obligation is in fact debt at all for this purpose.

These materials do not attempt to resolve any of those uncertainties, since the general rules for identifying and computing gain or loss and COD apply whatever the nature of the debtor.  It should be noted, however, that some of those uncertainties can be compounded by the legal relationships between creditors, some types of pass-through entities, and the owners of those entities.  A debtor's entity and pass-through status can make the characterizations required to apply those rules much more obscure.

Among the more confusing required determinations is the proper recourse characterization of debts which are recourse to a pass-through entity, but non-recourse to entity owners due to the entity's legal liability shield.

Once any characterization problems are resolved and a pass-through entity's gain or loss is computed, that gain or loss is taxed, usually to the entity's owners, under the rules of IRC Subchapters O and P.  Jeff's materials provide a description of the application of those rules in several specific types of transactions frequently seen in bankruptcy situations.

In most respects, once the amount of any gain or loss arising from pass-through entity debt cancellation is identified, the governing taxation rules are relatively straightforward.  Taxation of the COD portion of such transactions, however, can be somewhat more complex.

In considering the tax treatment of pass-through entity COD, it should be noted that cancellation of secured recourse debt is not the only possible source of that form of income in bankruptcy situations.  As examples, COD can arise from cancellation of unsecured debt, it can arise from modification of debt terms, and it can even arise from transfer of entity obligations from an unrelated to a related creditor.

The identification and measurement of potential COD from each of these sources can sometimes be a difficult task, but the rules, and related difficulties, in that area are not significantly different for pass-through entities and for other taxpayers.

As Jeff pointed out, however, COD is sometimes excluded from gross income for income tax purposes, and, when it is so excluded, there is sometimes a price for the exclusion in the form of a reduction of tax attributes.  The primary provisions governing available exclusions potential attribute reductions appear mostly in IRC secs. 108 and 1017.  And those IRC sections do provide special provisions, and concerns, for some pass-through entities.

Jeff's materials point out that a partnership debt's eligibility for the various provisions of IRC sec. 108(a), including the exclusions of debt discharged in a bankruptcy proceeding or discharged while the debtor is insolvent, is tested at the partner level under IRC sec. 108(d)(6).  Some of the tax difficulties which this provision generates for solvent partners in bankrupt partnerships are readily apparent; others, however, are less so.

Is this the place to discuss sec. 752, Babin, etc.?

The discussion so far has dealt with various considerations in the computation of pass-through entity taxable income, and in determination of the actual taxpayer, if any.  As suggested at the beginning of these materials, however, the timing of taxable income or deduction recognition can constitute another, and sometimes very significant, dimension in the tax analysis of bankruptcy situations transactions.

In his materials covering tax attribute utilization, and potential reduction, Jeff pointed out several rules which potentially impact the timing of taxation in bankruptcy situations.  In particular, Jeff noted the general rule of IRC sec. 1399 that no separate taxable entity results from a bankruptcy filing, and the major exception to that rule found in IRC sec. 1398 for individuals in Chapter 7 or Chapter 11 proceedings.

In his related discussion, Jeff identified a major potential attribute reduction problem for bankruptcy trustees or debtors in possession which can arise when debtors use a calendar year reporting period.  Tax attribute reduction under IRC sec. 108(b) occurs at the end of the year of debt discharge, but that year-end may precede the date when attributes would become usable.  If that occurs, the attributes may expire unused.

Jeff identified a series of possible solutions for that problem, and nothing in the taxation timing rules governing S corporations and partnerships seem to add anything to his list.  Most pass-through entities are also compelled to report on a calendar year-end basis.  There is one exception to that general requirement, however, and it creates significant planning opportunities in some bankruptcy situations.

While the IRC sec. 1398 individual bankruptcy estate is taxed under like an individual, it is still an estate.  Absent other controlling provisions, estates are permitted to select any taxable year-end date which they desire.  Since neither IRC sec. 1398(g), which identifies the debtor's tax attributes transferred to the estate, nor the Treasury Regulations under that IRC section indicate otherwise, a bankruptcy trustee or debtor in possession has complete freedom in selection of at least the estate's initial year end.

The ability to utilize a fiscal year end for an individual estate, particularly when it is combined with the IRC sec. 1398(j)(1) privilege of a subsequent estate year-end end change without Internal Revenue Service approval, provides significant flexibility in avoiding early tax attribute reductions due to excluded COD.  But when individual bankruptcy estates with those privileges own interests in other pass-through entities, even more significant planning possibilities become possible.

Income, gains and losses of S corporations and partnerships pass through to the entity's owners at the end of the entity's taxable year.  One of the principal reasons that pass-through entities such as S corporations and partnerships are restricted to reporting year ends, almost always the calendar year, is that individual owners reporting on a calendar year would otherwise be able to significantly defer the recognition of entity transaction for tax purposes by selecting a fiscal year end for the entity.  An individual bankruptcy estate cannot avoid a calendar year end for pass through entities in which it owns an interest; it can accomplish the same type of deferral, however, by placing itself on a fiscal year end.  And, in fact, it is permitted to do it twice!

Moreover, it is important to recognize that the potential deferral of income recognition is probably not the only tax planning opportunity inherent in the selection of differing owner and pass-through entity year ends.  For example, owners can, and do, engage in transactions with their pass-through entities, and every aspect of those transactions provides a potential tax planning opportunity.

To this point, these materials have dealt with issues related to the tax effects of income, gain or loss which pass-through entities generate from their own transactions, which in turn is passed through to their owners for tax reporting purposes.  It is important to keep in mind, however, that interests in those entities are often also among the major items of property in another debtor's bankruptcy estate.