Cancellation of Indebtedness Income Timing Issues

Joe Dawson

Dawson & Gerbic, LLP

Internal Revenue Code (“IRC”) sec. 1398(c), which governs the income taxation of an individual bankruptcy estate (an “Estate”), states:

(1) Computation and Payment of Tax. – Except as otherwise provided in this section, the taxable income of the estate shall be computed in the same manner as for an individual. The tax shall be computed on such taxable income and shall be paid by the trustee.

(2) Tax Rates. – The tax on the taxable income of the estate shall be determined under subsection (d) of section 1.

The few commentators who have addressed the issue have concluded that the wording of IRC sec. 1398(c)(2)’s rate designation for an Estate’s tax on its taxable income precludes other taxes on an Estate under IRC Subtitle A, Income Taxes. In fact, the original version of the preceding materials took that position a decade ago.

In one sense, of course, those commentators were correct; IRC secs. 1398 and 1(d) do seem to provide an exclusive formula for taxation based on an Estate’s taxable income. “Taxable income” is a defined term under IRC sec. 63, however, and it is not the only possible income taxation base. It is understandable that prior commentators may have elected not to apply one of the critical rules of statutory interpretation, namely “read on”; the statute in question is the IRC, so they might still be reading. Had they read on, however, they would have encountered some troublesome provisions.

IRC sec. 55(a), which creates the alternative minimum tax (“AMT”) states:

There is hereby imposed, (in addition to any other tax imposed by this subtitle) a tax equal to the excess (if any) of –

(1) the tentative minimum tax for the taxable year, over

(2) the regular tax for the taxable year.

Like IRC sec. 55, IRC sections 1 and 1398 are part of IRC Subtitle A, Income Taxes, so the Estate’s tax created under those sections is an “...other tax imposed by this subtitle....” for IRC sec. 55(a) purposes, and the AMT applies “in addition to” the tax under IRC secs. 1 and 1398 in any year that the other IRC sec. 55(a) requirement is met: namely, that the “tentative minimum tax” exceeds the “regular tax.”

For purposes of IRC sec. 55(a), “tentative minimum tax” and “regular tax” are also defined terms. IRC sec. 55(b)(1)(A)(i) defines “tentative minimum tax” as the “taxable excess” multiplied by the alternative minimum tax rates of 26% and 28%. IRC sec. 55(b)(1)(A)(ii), in turn, defines “taxable excess” as the portion of “alternative minimum taxable income” (“AMTI”) in excess of the applicable alternative minimum tax exemption, and IRC sec. 55(b)(2) defines AMTI as taxable income with the modifications required by IRC secs. 56, 57 and 58.

IRC sec. 55(c) defines “regular tax” for IRC sec. 55(a) purposes by reference to IRC sec. 26(b), with a few modifications inapplicable to this discussion. IRC sec. 26(b), in turn, defines “regular tax liability” as tax imposed by IRC Chapter 1,Normal Taxes and Surtaxes, for the taxable year, expressly excluding the AMT itself and numerous miscellaneous taxes, many of which were enacted after IRC sec. 55, but not excluding the tax on Estates under IRC secs. 1398 and 1(d). IRC secs. 1 and 1398 are part of IRC Chapter 1, so the tax computed under those IRC sections represents regular tax of an Estate for IRC sec. 55(a) purposes.

Based on the definitions in IRC secs. 55(b) and 55(c), it is clear that in any year that an Estate’s AMTI multiplied by the non-corporate AMTI rates exceeds the tax on that Estate’s taxable income created by IRC secs. 1398 and 1(d), IRC sec. 55(a) imposes the AMT on the Estate. Since the AMT is based on AMTI rather than on “taxable income”, it is not barred by the language of IRC secs. 1398 and 1(d), and the following flush language of IRC sec. 55(b)(2) seems to drive the stake home:

If a taxpayer is subject to the regular tax, such taxpayer shall be subject to the tax imposed by this section (and, if the regular tax is determined by reference to an amount other than taxable income, such amount shall be treated as the taxable income of such taxpayer for purposes of the preceding sentence.)

Tax based on taxable income appears to be precisely the type of tax to which Congress intended the AMT to be an alternative.

An AMT liability does not necessarily come into existence in every year; actual AMT liability only arises when the tentative minimum tax exceeds the regular tax. However, the AMT represents a complete tax system separate from and parallel to the regular tax system. This has at least two potentially significant consequences for an Estate.

First, while the liability payable in any year is the higher of that year’s regular tax or AMT, the two alternative computations must each be performed every year, on a cumulative basis, and each year’s results from each computation add to or utilize the tax attributes of that tax system. Any item properly utilized in either computation is deemed to have had a tax effect or benefit, even if the alternative computation produced the real tax liability for the year of use.

Two computational exceptions soften the parallel tax system impacts: to the extent that a difference between the AMT and regular tax computations causing an AMT payment will reverse in the future, that AMT payment generates a credit available beginning in the next year that the regular tax liability exceeds the AMT liability; and certain deductions which will never have a tax effect because of available credits are omitted from both alternative computations.

Second, nearly everything must be separately computed on both the regular tax and the AMT basis, including carry forward amounts and most limitations. This includes all items from flow-through entities such as partnerships and S corporations.

The separate computation rule also has simplifying modifications, however. For individuals, those computations based in any way upon adjusted gross income now require the use of regular tax adjusted gross income, even for AMT purposes. Furthermore, unless otherwise provided by statute, regulations, or other published Internal Revenue Service (“IRS”) guidance, all IRC regular taxable income provisions also apply to AMT computations. Unfortunately, however, quite a number of such differences, nearly all related to the availability or computation of statutory exclusions, deductions, and exemptions, have been mandated, and many of them are potentially relevant to Estates.

Some deductions available in computing regular taxable income are barred completely in computing AMTI. These include the standard deduction, personal exemptions, miscellaneous itemized deductions, income taxes, and most property taxes not incurred in carrying on a trade or business. It should be noted that the deductibility of bankruptcy administrative expenses in computing adjusted gross income, discussed in the preceding materials, avoids AMTI disallowance of those expenses as miscellaneous itemized deductions.

Even more regular tax deductions, exemptions and exclusions are permitted in computing AMTI, but with different limitations or computational formulas. One example is interest on personal residence mortgages. That interest remains deductible, but with two major limitations: transient residences, including some boats and mobile homes, do not qualify; and the regular tax deduction for interest on $100,000 of mortgage principal that was not used for residence acquisition or improvement is prohibited. Another example relates to depreciation expense: in some cases a longer depreciable life is required; and in others the IRC mandates a different depreciation method entirely.

AMT net operating losses (“NOLs”) and passive activity losses are computed under the regular tax formulas, but with AMT rules and adjustments. Annual AMT NOL utilization is limited to 90% of AMTI, however. Passive activity loss utilization, on the other hand, is not limited to a specified percentage of AMTI, but is subject to a special provision for insolvent taxpayers. Under IRC sec. 58(c)(1) the limitation on passive activity loss utilization to passive activity income is reduced for AMT purposes by the amount of a taxpayer’s insolvency at the close of any taxable year.

Superficially the IRC sec. 58(c)(1) passive activity insolvency provision appears to provide a significant benefit to an Estate, but in reality, because of the cumulative computations required under the separate AMT tax system, it is a double-edged sword. The insolvency exception might permit AMTI deduction of an otherwise unusable passive activity loss in the year of bankruptcy. On the other hand, an individual in bankruptcy was probably insolvent during taxable years preceding his or her petition, so passive activity loss carry forwards available for regular tax purposes may have been absorbed against AMTI, or converted to AMT NOLs, in prior years.

While IRC sec. 1398(c) does not absolve an Estate from alternative minimum tax exposure, it is somewhat less clear precisely what it does do. IRC sec. 1398(c)(1) mandates computation of taxable income “ the same manner as for an individual.”, and IRC sec. 1398(c)(2) requires determination of the regular tax on that income under IRC sec. 1(d), the subsection imposing income taxation on married individuals filing separate returns.

Read by themselves, those IRC sec. 1398(c) requirements suggest that an Estate might be subject to all of the various IRC provisions governing the taxation of married individuals filing separate returns. That interpretation draws some added plausibility from the fact that the Estate does, in fact, represent an individual.

Again, however, it is necessary to read on. All estates are subject to provisions very similar to IRC sec. 1398. IRC sec. 641(b), which governs general fiduciary taxation, states that

The taxable income of an estate or trust shall be computed in the same manner as in the case of an individual, except as otherwise indicated in this part....

Furthermore, IRC sec. 1398(c)(3) both identifies the taxpayer as an estate, and seems to distinguish that estate from the related individual by adding the requirement that the standard deduction “...shall be the same as for a married individual filing a separate return....”

All estates represent individuals, although some are deceased, and during bankruptcy proceedings the individual represented by the Estate will file his or her own returns covering the same periods as the Estate’s returns.

As stated above, nearly all IRC regular tax computational provisions also apply to computation of AMTI, and in the case of an Estate in bankruptcy, those provisions are almost certainly the ones related to estates rather than those related to married individuals filing separate returns. In a practical sense, this currently makes very little difference, because nearly all computational limitations and rules, other than the regular tax rates which are specifically dictated by IRC sec. 1, are the same for both of these filing statuses. Someday, though, it might matter again.

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