Partnership Bankruptcy Tax Issues

I. INTRODUCTION

Bankruptcies and restructurings involving partners and partnerships¹ raise a number of unique tax issues. While the Internal Revenue Service (the "IRS") has provided guidance with respect to a number of these issues, a surprising number of unresolved issues remain. The first part of this outline summarizes the state of the law with respect to general tax issues that typically arise in connection with partner and partnership bankruptcies and restructurings. The balance of the outline discusses tax issues that arise under Subchapter K when troubled partnerships are reorganized.

II. GENERAL ISSUES

A. Individual Partner Debtors and Their Estates

1. Creation of New Entity

For purposes of Federal, state or local income taxes, the filing of a bankruptcy petition for or against an individual partner creates a separate taxable entity.² The partner and the bankruptcy estate must file separate tax returns.

• The bankruptcy estate succeeds to the debtor's post-bankruptcy interest in the debtor's assets, including income, gain, loss and deductions of partnerships owned by the debtor.³
• For Federal income tax purposes, the bankruptcy estate succeeds to most of the debtor's tax attributes existing at the time of the bankruptcy filing.⁴ No new taxable entity is created for Federal income tax purposes where the debtor is a partnership or a corporation.⁵ State and local tax provisions of the bankruptcy code conform to Federal income tax treatment for these purposes.⁶
• "No Disposition Rule" The transfer of the debtor's assets to the individual's bankruptcy estate is not a taxable event.⁷ Thus, no gain or loss is recognized; no investment credit or depreciation is recaptured; and no installment gain is accelerated.⁸ Since the transfer of a partnership interest to a partner's bankruptcy estate is not a disposition, a bankruptcy filing by a partner does not trigger a partnership termination under section 708(b)(1)(B), does not close the partnership books with respect to the partner under section 706(c), and does not cause a change in interest under section 706(d).⁹ Treasury Regulations further provide that no sale or exchange occurs upon a disposition by gift (including assignment to a successor in interest).¹⁰ Presumably, the bankruptcy estate is a "successor in interest."
• Query whether the transfer of partnership liabilities to the bankruptcy estate creates a constructive distribution of money that triggers gain for the bankrupt partner if and to the extent the amount deemed distributed exceeds the partner's basis in his partnership interest.¹¹ This result would be contrary to the policy of section 1398(f)(1).

2. Taxable Years of an Individual Partner and the Bankruptcy Estate

• Bankruptcy Filing Does Not Close Individual's Taxable Year For the year of the bankruptcy filing, an individual partner reports all his income earned during the year, but does not include any income earned by the bankruptcy estate. Unless the individual elects to divide his taxable year (as described below), the corresponding tax is a liability of the partner rather than a claim against the partner's bankruptcy estate.¹² The treatment is different in the case of income and loss flowing from a partnership to a partner that files for bankruptcy. The Tax Court has interpreted section 706(a) as providing for the pass-through of a partner's share of partnership income, gain, loss and deduction on the last day of the partnership's tax year.¹³ Thus, if the partner's bankruptcy estate holds the partnership interest at the end of the year, the distributive share of the partnership's income and loss for the entire year is allocated to the bankruptcy estate, regardless of whether the individual partner elects to close his taxable year at the time of the bankruptcy filing (as described below).¹⁴
• For state and local income tax purposes, the debtor's tax year terminates only if, and to the extent that, the debtor's tax year terminates for Federal income tax purposes.¹⁵
• Federal income tax refunds (or portions thereof) attributable to periods prior to the filing of the bankruptcy petition will likely be treated as property of the bankruptcy estate.¹⁶
• Individual Partner Election to Close His Taxable Year An individual partner can elect, without permission, to close his taxable year as of the day before the commencement of the bankruptcy case.¹⁷ If the election is made, the individual partner's taxable year is divided into two short taxable years.¹⁸ The first short year begins on the first day of the individual's normal taxable year and ends on the day before the commencement date.¹⁹ The second short year begins on the commencement date and ends on the last day of the individual's normal taxable year.²⁰
• The individual's Federal tax liability for the first short year is determined based on the partner's tax attributes available immediately before the partner's assets are transferred to his estate. The tax liability becomes a claim against the bankruptcy estate. This claim is a pre-petition liability, subject to eighth priority, and is not dischargeable.²¹ Accordingly, the individual bears the ultimate burden for payment of any portion of the liability not satisfied by the bankruptcy estate.²²
• The tax liability for the second short year (including tax attributable to the partnership's taxable year ending with or within the second short year) is a liability of the bankruptcy estate.
• The tax liability of an individual debtor's estate is an administrative expense.²³ An individual debtor is discharged from personal responsibility for any unpaid bankruptcy estate tax liability.²⁴
• In a declaratory judgment action, the Supreme Court held that a trustee appointed to liquidate property transferred by a bankrupt corporation to a trust created pursuant to a Chapter 11 plan must, as a fiduciary of the trust, file returns and pay taxes due on income attributable to the debtor's property.²⁵
• Termination of Bankruptcy Proceeding When the bankruptcy estate terminates, the individual debtor succeeds to the assets and the tax attributes of the bankruptcy estate in a nontaxable transfer.²⁶ Query whether this transfer can effect a termination of the partnership and/or produce section 731 gain.

B. Partnership Debtors and Their Estates

1. Creation of New Entity

The commencement of a Title 11 case for a partnership does not create a new taxable entity for Federal income tax purposes.²⁷ Thus, no gain or loss is recognized by the partnership in connection with a deemed asset transfer, no tax credits are recaptured, and the partnership's tax year does not end.²⁸

• The debtor partnership continues to use its historic taxpayer ID number.²⁹
• The consolidation of a group of related partnerships for bankruptcy proceeding purposes does not constitute a consolidation or merger of the partnerships for tax purposes.³⁰
• The bankruptcy of a member of a consolidated group causes its partnership items to convert to non-partnership items.³¹ After the conversion, the other members of the consolidated group will no longer have their tax liability determined by reference to these items as "partnership items," and will no longer be considered "partners" under section 6231(a)(2)(B) with respect to the bankrupt corporation's separately held items.³²

2. Post-Petition Tax Returns and Liability

The trustee of a partnership in bankruptcy is responsible for filing the partnership's tax returns for periods after the petition date.³³

• Post-petition partnership income or gain will be passed through to the partners, which will create phantom income because the assets of the partnership may not be used to make tax distributions to partners.³⁴

C. Abandonment of Property by Bankruptcy Estate

• After notice and hearing, a trustee may abandon "burdensome" property to an individual debtor or his creditors during a bankruptcy proceeding.³⁵ A trustee may be motivated to abandon property whose sale would cause the estate to realize a taxable gain without generating cash sufficient to pay the tax, because unpaid bankruptcy estate taxes are pari passu with trustee fees.³⁶ The IRS and several courts have held that an individual's bankruptcy estate should not recognize gain when property is abandoned.³⁷ These authorities rely on section 1398(f)(2) to hold that the abandonment of property is not a sale or exchange of assets, because it is a transfer from the estate to the debtor pursuant to the termination of the estate.
• The bankruptcy court in A.J. Lane³⁸ declined to follow the authorities cited above. In A.J. Lane, the trustee requested authority to abandon property of the estate, shifting the tax consequences of a subsequent foreclosure to the debtor. The court denied the trustee's request, determining that the estate would be liable for tax on the abandonment, because although section 1398(f)(2) is applicable only at the "termination" of the estate, it would be asymmetrical to have a tax-free transfer of an asset back to the individual before the individual received his other tax attributes under section 1398(i). The court acknowledged that its decision was contrary to Olson and McGowan. Although the A.J. Lane opinion may constitute a literally correct reading of section 1398(f)(2), courts may decline to follow the decision for policy reasons.³⁹

Footnotes

1 References to partnerships in this article are generally equally applicable to limited liability companies that are subject to Federal income tax as partnerships under the "check-the-box" Treasury regulations.

2 Internal Revenue Code of 1986, as amended (the "I.R.C.") § 1398(d)(1).

3 I.R.C. § 1398(b)(2); Bankruptcy Code (the "BC") § 346(b).

4 I.R.C. § 1398(g). The bankruptcy estate does not succeed to the debtor's passive activity losses. If the bankruptcy estate disposes of the debtor's entire partnership interest, any partnership-generated passive activity losses allocable to the partnership interest would then be treated as losses that are not from a passive activity pursuant to section 469(g). Priv. Ltr. Rul. 93-04-008 (Oct. 27, 1992).

5 I.R.C. § 1399.

6 See BC § 346(b), (i).

7 I.R.C. § 1398(f)(1).

8 H.R. Rep. No. 96-833, at 25 (1980); S. Rep. No. 96-1035, at 31 (1980).

9 See Gulley v. Commissioner, T.C. Memo 2000-190 (2000).

10 Treas. Reg. § 1.708-1(b)(2).

11 I.R.C. §§ 731(a)(1), 752(b).

12 See In Re Mirman, 98 B.R. 742 (Bankr. E.D. Va. 1989), 89-1 U.S.T.C. ¶ 9297.

13 See Katz v. Commissioner, 116 T.C. 5 (2001); Gulley v. Commissioner, T.C. Memo 2000-190 (2000).

14 See Katz v. Commissioner, 116 T.C. 5 (2001); Gulley v. Commissioner, T.C. Memo 2000-190 (2000).

15 BC § 346(d).

16 See In re Wilson, 49 B.R. 19 (Bankr. N.D. Tex. 1985); C.C.A. 1999- 41-002 (Oct. 15, 1999).

17 I.R.C. § 1398(d)(1), (2).

18 I.R.C. § 1398(d)(2)(A).

19 I.R.C. § 1398(d)(2)(A)(i).

20 I.R.C. § 1398(d)(2)(A)(ii).

21 BC § 507(a)(8).

22 BC § 523(a)(1).

23 BC § 503(b)(1)(B). Any remaining tax attributes of the estate, including carryforwards, revert to the individual when the estate is terminated. I.R.C. § 1398(i). Although beneficial to the taxpayer, this treatment is asymmetrical.

24 BC § 727(b). As a practical matter, a Chapter 11 plan cannot be confirmed absent provision for payment in full of all administrative claims, including bankruptcy estate income taxes. If a bankrupt estate lacks sufficient funds to pay these taxes, the case would ordinarily be converted to a Chapter 7 liquidation case.

25 I.R.C. § 6012(b)(4); Holywell Corporation v. Smith, 503 U.S. 47 (1992).

26 I.R.C. § 1398(f)(2), (i).

27 I.R.C. §§ 1398(b)(2); 1399.

28 I.R.C. §§ 1398(b)(2); 1399.

29 I.R.S., Do You Need a New EIN?, available at http://www.irs.gov/businesses/small/article/0,,id=98011,00.html.

30 FSA 1999-52-016 (Sept. 24, 1999

31 FSA 2002-03-007 (Sept. 28, 2001).

32 FSA 2002-03-007 (Sept. 28, 2001).

33 I.R.C. § 6012(b)(3); Rev. Rul. 79-120, 1979-1 C.B. 382; see H.R. Rep. No. 96-833, at 21 (1980); S. Rep. No. 96-1035, at 26 (1980).

34 See BC § 541(a)(6).

35 BC § 554(a). It should be noted that lifting the automatic stay against property of the bankruptcy estate generally does not, without more, constitute abandonment of the property by the bankruptcy estate. See Catalano v. Commissioner, 89 A.F.T.R.2d 2002-707 (9th Cir. 2002).

36 BC § 503(b)(1), (5).

37 For an excellent discussion of these issues, see Onsager, Assigning Tax Liability between the Bankruptcy Estate and the Individual Debtor, 75 J. Tax'n 102, 103 (Aug. 1991). See, e.g., In re Olson, 930 F.2d 6 (8th Cir. 1991) (real estate abandoned by a Chapter 7 trustee was later sold at foreclosure; court determined that debtor was taxable on the gain realized at foreclosure and that a taxable exchange had not occurred earlier when the property was abandoned); In re McGowan, 95 Bankr. 104 (N.D. Iowa 1988) (Chapter 7 trustee abandoned machinery in which the debtor had no equity; relying on section 1398(f)(2), the court determined that the estate was not liable for income tax from the abandonment, because termination of an estate includes termination of an interest in property due to abandonment); Priv. Ltr. Rul. 90-17-075 (Jan. 31, 1990); Priv. Ltr. Rul. 89-18-016 (Jan. 31, 1989).

38 In re A.J. Lane & Co., 133 Bankr. 264 (1991).

39 See In re Olson, 100 B.R. 458, 463, aff'd, 121 Bankr. 3 (N.D. Iowa 1990), aff'd, 930 F.2d 6 (8th Cir. 1991). Defining termination of the estate as the closing of a case "would prevent the assignment of tax consequences to the estate when property is abandoned by operation of law as a result of its being unadministered at the close of a case." The court saw no reason why abandoning property during administration of a case should be treated differently than at the close of a case.

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