You, as the individual debtor, generally must file income tax returns during the period of the bankruptcy proceedings. Do not include on your return, the income, deductions, or credits belonging to the separate bankruptcy estate. Also do not include as income on your return, the debts canceled because of bankruptcy. However, the bankruptcy estate must reduce certain losses, credits, and the basis in property (to the extent of these items) by the amount of canceled debt. See Debt Cancellation, later.

You have the option of ending your tax year on the day before you filed your bankruptcy petition. This allows the tax due on that short period return to be a claim against the bankruptcy estate. See Election to End Tax Year, later.

See Tax Procedures, later, for information about determining and paying the amount of tax due.

If you are an individual debtor and have assets (other than those you exempt from the bankruptcy estate), you may choose to end your tax year on the day before the filing of your bankruptcy case. Then your tax year is divided into 2 “short” tax years of fewer than 12 months each. The first year ends on the day before the filing date, and the second year begins with the filing date and ends on the date your tax year normally ends. Once you make this choice, you may not change it. Any income tax liability for the first short tax year becomes an allowable claim (as a claim arising before bankruptcy) against the bankruptcy estate. If this tax liability is not paid in the bankruptcy proceeding, the liability is not canceled because of bankruptcy and it can be collected from you as an individual.

If you do not choose to end the tax year, then no part of your tax liability for the year in which bankruptcy proceedings begin can be collected from the estate.

The filing of a bankruptcy petition for an individual debtor under chapter 7 or chapter 11 of the bankruptcy code creates a separate taxable bankruptcy estate. The trustee (for chapter 7 cases) or the debtor-in-possession (for chapter 11 cases) is generally responsible for preparing and filing the estate's tax returns and paying its taxes. The debtor remains responsible for filing returns and paying taxes on any income that does not belong to the estate.

If a bankruptcy case begins, but later is dismissed by the bankruptcy court, the estate is not treated as a separate taxable entity. If tax returns have been filed for the estate, amended returns must be filed to move income and deductions from the estate's returns to the debtor's returns. If no returns have been filed, report all income and deductions on the debtor's returns.

The following discussions provide tax information for the bankruptcy estate.

The trustee (or debtor-in-possession) must file an income tax return on Form 1041, U.S. Income Tax Return for Estates and Trusts if the estate has gross income that meets or exceeds the amount required for filing. This amount is the total of the personal exemption amount and the basic standard deduction for a married individual filing separately. See the Form 1041 instructions for the current year's amount.

If a return is required, the trustee (or debtor-in-possession) completes the identification area at the top of the Form 1041 and lines 23—29 and signs and dates it. Form 1041 is a transmittal for Form 1040, U.S. individual Income Tax Return. Complete Form 1040 and figure the tax using the tax rate schedule for a married person filing separately. In the top margin of Form 1040, write “Attachment to Form 1041. DO NOT DETACH.” Attach Form 1040 to the Form 1041.

The filing requirements for a partnership in bankruptcy proceedings do not change. However, the filing of required returns becomes the responsibility of an appointed trustee, receiver, or a debtor-in-possession rather than a general partner.

A partnership's debt that is canceled because of bankruptcy is not included in the partnership's income. It may or may not be included in the individual partners' income. See Partnerships, later under Debt Cancellation.

The following discussion covers only the highlights of the bankruptcy tax rules applying to corporations. Because the details of corporate bankruptcy reorganizations are beyond the scope of this publication, you may want to seek the help of a professional tax advisor.

See Corporations under Debt Cancellation, for information about a corporation's debt canceled because of bankruptcy.

The tax-free reorganization provisions of the Internal Revenue Code apply to a transfer by a corporation of all or part of its assets to another corporation in a title 11 or similar case, but only if, under the reorganization plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction qualifying under IRC section 354, 355, or 356.

A “title 11 or similar case,” for this purpose, is a bankruptcy case under title 11 of the United States Code, or a receivership, foreclosure, or similar proceeding in a federal or state court, but only if the corporation is under the jurisdiction of the court in the case and the transfer of assets is under a plan of reorganization approved by the court. In a receivership, foreclosure, or similar proceeding before a federal or state agency involving certain financial institutions, the agency is treated as a court.

Generally, section 354 provides that no gain or loss is recognized if a corporation's stock is exchanged solely for stock or securities in the same or another corporation under a qualifying reorganization plan. In this case, shareholders in the bankrupt corporation would recognize no gain or loss if they exchange their stock solely for stock or securities of the corporation acquiring the bankrupt's assets.

Section 355 generally provides that no gain or loss is recognized by a shareholder if a corporation distributes solely stock or securities of another corporation that the distributing corporation controls immediately before the distribution. Section 356 provides that in an exchange that would qualify under section 354 or 355 except that other property or money besides the permitted stock or securities is received by the shareholder, gain is recognized by the shareholder only to the extent of the money and the fair market value of the other property received. No loss is recognized in this situation.

The filing requirements of a corporation involved in bankruptcy proceedings do not change. However, the filing of required returns becomes the responsibility of an appointed trustee, receiver, or a debtor-in-possession, rather than a corporate officer.

A corporation that is subject to the jurisdiction of the cout in a title 11 or similar case is exempt from the personal holding company tax, unless the main reason for beginning or continuing this case is to avoid paying this tax. A“ title 11 or similar case” is defined earlier under Tax-Free Reorganizations.

The first step in the determination of the tax due is filing a return. As an individual bankrupt debtor, you file a Form 1040 for the tax year involved, and the trustee of your bankruptcy estate files a Form 1041, as explained earlier under Individuals in Chapter 7 or 11. A bankrupt corporation, or a receiver, bankruptcy trustee, or assignee having possession of, or holding title to, substantially all the property or business of the corporation, files a Form 1120 for the tax year.

After the return is filed, the Internal Revenue Service may redetermine the tax liability shown on the return. When the administrative remedies within the Service have been exhausted, the tax issue may be litigated either in the bankruptcy court or in the U.S. Tax Court, as explained in the following discussion.

The appropriate form for the trustee to use in making the claim for refund is as follows:

The IRS examination function, if requested by the trustee or debtor-in-possession as discussed later, will examine the appropriate amended return, claim, or original return tiled by the trustee on an expedite basis, and will complete the examination and notify the trustee of its decision within 120 days from the date of filing of the claim.

After the filing of a bankruptcy petition and during the period the debtor's assets or those of the bankruptcy estate are under the jurisdiction of the bankruptcy court, these assets are not subject to levy. The Internal Revenue Service may file a proof of claim in the bankruptcy court the same way as other creditors. This claim may be presented to the bankruptcy court even though the taxes have not yet been assessed or are subject to a Tax Court proceeding.

There are several exceptions and exclusions from the inclusion of canceled debt in income. The exceptions include:

The exclusions are discussed next.

Do not include a canceled debt in gross income if any of the following situations apply:

If any amount of the debt cancellation is used to reduce the basis of assets as discussed under Reduction of Tax Attributes, the following rules apply to the extent indicated.

The sample tilled-in Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), shown in this publication is based on the following situation.

Tom Smith is in financial difficulty, but he has been able to avoid declaring bankruptcy. In 1995, he reached an agreement with his creditors, whereby they agreed to forgive $10,000 of the total that he owed them, in return for his setting up a schedule for repayment of the rest of his debts.

Immediately before the debt cancellation, Tom's liabilities totaled $120,000 and the fair market value of his assets was $100,000 (his total basis in all these assets was $90,000). At the time of the debt cancellation, he was considered insolvent by $20,000. He can exclude from income the entire $10,000 debt cancellation because it was not more than the amount by which he was insolvent.

Among Tom's assets, the only depreciable asset is a rental condominium with an adjusted basis of $50,000. Of this, $10,000 is allocable to the land, leaving a depreciable basis of $40,000. He has a long-term capital loss carryover to 1996 of $5,000. He also has a net operating loss of $2,000 and a $3,000 net operating loss carryover from 1994. He has no other tax attributes arising from the current tax year or carried to this year.

Ordinarily, in applying the $10,000 debt cancellation amount to reduce tax attributes, Tom would first reduce his $2,000 net operating loss, next his $3,000 net operating loss carryover from 1994, and then his $5,000 net capital loss carryover. However, he figures that it is better for him to preserve his loss carryovers for the next tax year.

Tom elects to reduce basis first. He can reduce the depreciable basis of his rental condominium (his only depreciable asset) by $10,000. The tax effect of doing this will be to reduce his depreciation deductions for years following the year of the debt cancellation. However, if he later sells the condominium at a gain, the part of the gain from the basis reduction will be taxable as ordinary income.

Tom must file Form 982, as shown here, with his individual return (Form 1040) for the tax year of the debt discharge. In addition, he must attach a statement describing the debt cancellation transaction and identifying the property to which the basis reduction applies. This statement is not illustrated.