TAXNEWS&VIEWS

By Elmer Dean Martin III

I. Subchapter V: Does it belong in Chapter 11, 12 or 13?

A. Why Does Subchapter V1 Create Income Tax Confusion?

A Subchapter V case of an individual looks a little bit like a Chapter 12 or 13 case. There are trustees and debtors in possession in all three case types. A Subchapter V debtor can confirm a plan without creditor approval and so can a Chapter12 or13 debtor. Theremayormaynot bedifferences in whethertheincome of the debtor is property of the bankruptcy estate.

A review of the history of Subchapter V and the materials intended to guide the parties in operating in a Subchapter V case indicates that no thought was given to whether special income tax considerations apply in Subchapter V cases.2 Indeed, the legislative history misstates a very important distinction in section 1186 with income tax significance.3

The House Report states that section 1186 mandates inclusion of a debtor’s post-petition income in the debtor’s estate. Section 1186(a) states: “If a plan is confirmed under section 1191(b) of this title, property of the estate includes . . . earnings from services performed by the debtor.” However, if a plan is confirmed under section 1191(a), which allows confirmation by creditor consensus, the income of the debtor from the debtor’s services is not included in the estate.

The consequence of this distinction, as discussed hereinafter, is that at the beginning of every Subchapter V case the income tax reporting and payment obligations of the trustee or debtor in possession are not known because at the time

1 “Subchapter V” refers to the provisions of the Bankruptcy Code added by the Small Business Reorganization Act of 2019, Pub. L. No. 116-54, 133 Stat. 1079.

2 H.R. REP NO. 116-171 (July 23, 2019)

3 Id. at page 6: “New section 1186 concerns property of the estate. Subsection (a) provides that a plan is confirmed, property of the state includes all property acquired by the debtor after the date of commencement of the case . . . It also includes all earnings from services performed by the debtor during such period.” of the case commencement nobody knows whether the estate will own the debtor’s income as a result of a plan cramdown rather than consensual acceptance by the creditors.4

In Chapter 11 plans which are not Subchapter V plans a debtor’s income is property of the estate under section 1115. Section 1181 provides that section 1115 does not apply in Subchapter V cases. As noted, the conjunction of Subchapter V confirmation rules and income tax rules creates complications in confirming a Subchapter V plan simply because it may not be known what the income of a Subchapter V estate is until it is known if a plan confirmation will be consensual or cramdown. Because the income must be known, reported, and any taxes paid in order to confirm a plan, a debtor has a dilemma. This just one example of the issues which can arise because of the intersection of I.R.C. sections 1398 and 1399 with the Bankruptcy Code.5

Another interesting possible conflict arises from the conjunction of section 1141(b), which revests property of the estate upon confirmation unless provided otherwise in the plan, and section 1186(a) which includes future earnings in the estate if confirmation is a cramdown until the “case is closed, dismissed or converted to a case under Chapter 7, 12 or 13 . . .” This seems to mean that the estate reports the income of the debtor until the debtor’s plan is fully consummated and the case is closed which implies that section 1141(b) does not apply.6 Also,

4 What it means to “own a debtor’s income” is a complex subject in itself. The same issue arises in Chapter 12 and 13 cases, but in those cases the income of the debtor will always be income of the estate. Suppose the debtor is a wage earner. Is the debtor’s estate subject to employment taxes and income tax withholding? In 2006, the IRS promulgated a comprehensive Notice regarding reporting of personal income as required by § 1115. I.R.S. Notice 2006-83, I.R.B. 2006-40 (Oct. 2, 2006). The Office of the United States Trustee concurrently issued a form entitled “Certification of Receipt and Understanding of Notice – Individual Chapter 11 DebtorIRS Filing and Reporting Requirements Under Section 1115 Of The Bankruptcy Code” which was supposed to be signed by every individual filing a Chapter 11 case and which acknowledges that the debtor has read and understood the notice. However, I’m not aware that any Chapter 11 individual debtor has ever been required to sign this form.

5 11 COLLIER ON BANKRUPTCY ¶¶ 1.03, 2.03, 2.07, 3.01, 3.02, 3.03 and 3.06 (16th ed.). has a discussion of issues arising out of §§ 1398 and 1399, some of which are discussed herein, which would impress the reader as a collection of arguments similar to arguments as to how many angels can dance on the head of a pin. However, failure to do the dance can be detrimental to a debtor’s advisers who ignore the dance, while advisers who represent creditors, debtors and guardians of the federal and state fiscs are good dancers.

6 When an estate terminates for income tax purposes, and income is no longer included in the estate, is not necessarily easy to determine. See supra note 5. Generally, in a Chapter 11 plan, in addition conversion to Chapter 12 or 13 will continue inclusion of post-petition income in the estate notwithstanding section 1186(a). Section 1190(2) seems to make the trustee responsible for administration of what may be income of the estate after confirmation.

B. Tax Substantive Law Fundamentals

All bankruptcy lawyers filing bankruptcy cases for individuals are expected to know some fundamental tax laws applicable in bankruptcy cases of individuals. Oftenthesefundamentals areoverlookedandthepersonsresponsibleforcompliance with the tax laws escape consequences simply because these fundamentals are not known by the debtors and creditors affected by noncompliance with these laws or by judges charged with confirming only plans which conform to these laws. These are:

1. The bankruptcy estate of an individual in Chapter 7 and 11 cases is a taxable entity separate from the individual debtor.7

2. The gross income of the estate under title 26 U.S.C. includes the gross income of the individual debtor to which the estate is entitled under title 11 U.S.C.8

3. The individual debtor may elect to terminate the debtor’s tax year as of the case commencement date in order to allow prepetition income tax liabilities of the debtor for the year of filing to be paid by the debtor’s estate if the estate has assets.9 to an “effective date” there should also be an explicit “not effective” date.

7 I.R.C. § 1398 (2023) How much of what is discussed here applies to bankruptcy estates of individuals for state income tax purposes warrants an exegesis solely on this subject. I don’t even concede that there is a California income tax law which imposes an income tax on bankruptcy estates of individuals. See E. Martin, In Bankruptcy Planning Consider Federal and State Law, TAXATION FOR ACCOUNTANTS, May 1991 at 285; E. Martin, In Bankruptcy Planning Consider Federal and State Law, TAXATION FOR LAWYERS, August 1991 at 23. I litigated this issue in In re Hollingsworth, CaseNo.2:96-bk-52815 (Bankr.C.D.Cal.1996). Californiasettledinasealedsettlementagreement, Docket No. 579, when threatened with having to refund every tax ever collected by California from the bankruptcy estate of an individual, Chapter 7 or 11

8 Id.

9 Id. See In re Turboff, 93 B.R. 523 (Bankr. S.D. Tex. 1988) (debtor failed to elect to close his tax year when he filed his bankruptcy case on July 27, 1987, and accordingly the debtor was required to

4. A trustee or debtor in possession is required to file annual income tax returns for the debtor’s estate and pay any income taxes due.10

5. The bankruptcy estate of an individual in a Chapter 12 or 13 case is not a taxable entity separate from the debtor.11

6. If the debtor owns interests in pass through entities (partnerships, LLCs or Subchapter S corporations) the income or losses for the entire year of filing pass through to the estate.12

7. If an individual owns interests in pass through entities which file a bankruptcy case any income earned by the pass through entities will be taxed to the individual even though all cash owned by the entities will go to the entity’s creditors.13

8. If an individual owns property which has no equity and if sold will generate a taxable gain the filing of a bankruptcy case by the individual will convert the gain from potentially not taxable to taxable.14 pay income taxes on 1987 income incurred before his case commencement even though all of his property went to his bankruptcy estate). Special issues arise if only one spouse files a bankruptcy case, especially in community property states.

10 Turboff, 93 B.R. 523 See also I.R.C. § 6012(a)(8) and (b)(3) and (b)(4) (2023)

11 Turboff, 93 B.R. 523 See also I.R.C. § 1399 (2023)

12 I R S Chief Counsel Advice Memorandum 200217003 (Dec 14, 2001), citing Gulley v. Comm’r, T.C.M. 2000-190, 79 T.C.M. (CCH) 2171 (2000) and Katz v. Comm’r, 116 T.C. 5 (2001).

13 E. Martin, To File an Income Tax Return or Not to File – What Should a LLC Chapter 7 Trustee Do?, 35CAL. BANKR.J. 171 (2020).

14 For example, a foreclosure of a lien on real estate before filing of a case could generate income which is not subject to taxation because I.R.C. § 108 (2023) considers debt of an insolvent debtor discharged to be not taxable. However, if the debtor owned the property when he filed his case and the trustee abandoned the property back to the debtor after which it was foreclosed, then the gain on the sale is capital gain on which the debtor must pay income taxes. See E. Martin, Is Debt Cancellation Income Resulting From a Discharge of Nonrecourse Debt in Foreclosures in 2009 and 2010 excludible from income or eligible for deferral?, 30 CAL. BANKR.J. 313, 319 n.13:

ItshouldbenotedinpassingthatasappliedbytheIRS thereisa trap fortheunwary bankruptcy attorney here because recourse debt is converted into nonrecourse debt by a bankruptcy discharge. See Priv. Ltr. Rul. 8918016 (Jan. 31, 1989). Accordingly, foreclosure of property owned by a debtor post-discharge and after abandonment or case closing would result in taxable gain under the present

9. An abandonment of an asset from an individual’s estate will for tax purposes result in the asset being considered always an asset of the individual.15

10. If a trustee does not abandon an asset which has no equity and the asset is disposed of by the estate through foreclosure or otherwise and the disposition generates a taxable gain for the estate the trustee may be personally liable for the tax on the gain either to creditors of the estate if there are other assets or to the IRS.16

C. Tax Procedural Law Fundamentals.

Although it may be difficult to determine what the income of a Subchapter V case estate may be, the reporting of that income and payment of taxes on that income, whatever it is, is similar in both Chapter 11 cases in general and in Subchapter V cases in particular.

In all Chapter 11 cases, including those under Subchapter V, a plan may not be confirmed unless all prepetition and post-petition returns are filed and taxes reported are paid. If a plan is consensual then there may be no income taxes on personal service income of the debtor for the estate to report and pay because the income will not be the estate’s property. If the plan is not consensual then the plan cannot be confirmed until the returns are filed for the income and the taxes on the income are paid. Strangely this seems to require the debtor to solicit acceptances of a plan before a plan can be the subject of a disclosure statement or a plan proposal.

interpretation of § 1.1001-2, whereas in a pre-bankruptcy foreclosure the gain would generally be excluded from taxable income by § 108. Consequently every bankruptcy case which includes encumbered real property with recourse debt requires a tax analysis under § 1001 as well as § 1398. The latter relates to the electiontoterminatethedebtor'staxyearuponcommencementofacasecontaining assets, which, although it is a tax law, should be considered to be within the responsibility of bankruptcy lawyers to advise their clients, at least to the extent that they must seek timely tax counsel as to the advisability of that election. Many consumer bankruptcy lawyers have a standard § 1398 provision in their retainer agreement and those that do not, should.

15 Mason v. Comm’r, 646 F.2d 1309 (9th Cir. 1980).

16 See note 14 supra.

1. 11 U.S.C. § 1184 (small business debtors under Subchapter V must comply with the requirements of section 1106(a)(6).

2. 11 U.S.C. § 1191(a) (providing that requirements of section 1112 apply in Subchapter V).

3. 11 U.S.C. § 1191(a) (applying section 1129(a)(2)’s “Code compliance” confirmation requirement to cases under Subchapter V).

4. 11 U.S.C. § 1112(b)(4)(I) (debtors must “timely pay taxes owed after the date of the order for relief” or face conversion or dismissal of case).

II. Subchapter V belongs in Chapter 11 But Subchapter V Cases May Have Income Tax Issues Different From Other Chapter 11 Cases.

Ironically it may be observed that the similarities between Subchapter V and Chapters 12 and 13 have createdinquirybybankruptcylawyersintowhether income tax issues in Subchapter V cases are the same or similar to those in Chapters 12 and 13. The general answer is that the same tax laws apply in all subchapters of Chapter 11 and in Chapters 12 and 13, but they apply in some respects differently because of the different property rights regulated by the different chapters. Also, there is no doubt about whether Subchapter V is in Chapter 11 despite resembling Chapters 12 and 13.

The attempt to transport income tax concepts between the chapters of the Bankruptcy Code often creates complicated controversies. Section 1232 of the Bankruptcy Code resulted from one of such complicated controversies. In Hall v. United States17 the Chapter 12 debtor sold property of his estate and the sale resulted in a tax due as a result of the sale. The debtor claimed that the tax was due from the estate and not from him. The Supreme Court held that the income tax from the sale of the property of the estate could not be “incurred by the estate” because for tax purposes a Chapter 12 case does not create an estate separate from the debtor and therefore “the tax liability resulting from Petitioners’ post-petition farm sale . . . is neither collectible [from the estate] nor dischargeable in the Chapter 12 plan.”

Section 1232 was enacted to allow the income taxes resulting from the sale of farm property to be paid from the Chapter 12 estate and to be discharged. A review of the court decisions applying section 1232 reveals how an income tax controversy which arose from the application of the Internal Revenue Code in a bankruptcy case continues to live on even after enactment of section 1232 which was intended to end that controversy.

17 566 U.S. 506 (2012).

The bottom line of all this discussion about I.R.C. §§ 1398 and 1399 is that lawyers and accountants should be careful about considering these sections in any bankruptcy case involving an individual because while the lawyers and accountants in the case may, and often do, ignore these tax laws, the lawyers and accountants representing creditors, debtors and government entities may be aware of and enforce them. One CPA who lives and breathes bankruptcy told me that during his entire long career dealing with bankruptcy tax issues he had never even once filed an election to terminate an individual’s tax year as of the date of the commencement of the debtor’s bankruptcy case and had never even heard of such an election. As noted above, this can have unfortunate consequences for the accountant as it did for the bankruptcy lawyers in the case cited above.18 tbisconti@bklwlaw.com

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