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Bankruptcy Taxation
St. Johns University School of Law
Todres, Jacob L.

Bankruptcy Taxation Outline
Prof. Todres
Fall 2010
 
 
 
Introduction
Basic Tax Concepts
·         (Very) Basic Tax Structure
o   Gross Income
o   Less deductions
o   = Taxable Income
§ Multiplied by tax rate
o   = Tentative tax
§ + AMT
§ Less Tax Credits
o   = Tax Due
·         Income
o   Is very broadly defined
o   § 61: The starting point for the entirety of the tax system is the inclusion provision
§ “all income, from whatever source derived”
·         “undeniable ascension to wealth, clearly realized and over which taxpayer has complete dominion → Glenshaw Glass
o   on top of the basic inclusion provision, the code provides a list of specific inclusions
§ Which, for this course, includes income from discharge of indebtedness
·         BUT: need not be specified to be income
o   POINT: default is that if in doubt, it is income
·         Deductions:
o   Deductions, unlike income, are narrowly drawn. If it is not listed, it can not be deducted
§ Further, even some deductions that are normally allowed, are disallowed in certain circumstances
·         §267(a): sale of property at a loss is not deductible if sold to certain relatives, as defined by statute
·         §269: acquisitions made to evade or avoid income tax
·         §465: losses are limited to amount actually at risk
·         §469: Passive activity loss limitation on deductions
o   The major deductions (that we will focus on)
§ Expenses incurred in the production of income
§ Net Operating Losses
·         Stay tuned, but: allows TP to calculate gains and losses over a long period of time, and can result in an actual cash infusion and tax refund. NOLs can be very valuable
§ Depreciation (to an extent)
o   Tension between capitalization and deductions
§ Expenses are fully deductible
§ Capital expenditures, though, are assets. They must be capitalized, and can only be deducted over a longer period of time
·         Either through depreciation,
·         Or just given basis in the asset, which does not even allow for a deduction in the true sense of the word, merely a decrease in the amount realized on the event of a sale of the asset
o   Basic possible treatments of expenditures of money can be arranged in a continuum:
 
¾Tax Credits¾¾Deductions¾¾Capital Expenditures¾¾Completely Ignored (totally taxed)¾
 
→ left to right is more beneficial to the TP
 
Substance and Form
·         Because of this, the substance and form of an expenditure or transaction can be very significant
o   Taxpayers often seek to characterize transaction one way, and IRS another.
§ Sham Transactions: even where the letter of the tax law is followed – meticulously – it may be disregarded where the transaction was a mere device for purpose of hiding and disguising real object and purpose
·         Economic Substance test: as a test of a transaction: does the trans have any substance, or is it in name only? If so, what is it? How does it matter
·         Business purpose test: is there a legitimate business purpose for this way of doing things?
§ These tests are very hard to pin down, and make advising a client very difficult. Further, while similar to §269, these tests are not even in the code – the Sham Transaction rule is a judicially developed cases law doctrine
o   Hypo: Instead of purchasing machinery for 1 million, “lease” it for $500,000 per year for first two years, and $1 per year for the eight years thereafter that machine will last
§ Why? By renting instead of buying, can turn this transaction into a rental, which is a deductible business expense, as opposed to an asset, which must be depreciated, with its deduction obtained over time.
§ Is this a Sham Transaction? No real way to know
o   Hypo: Corporate acquisition, stock for stock. Month later, liquidate target corp; end up with all of its assets.
§ Why? Stock for stock is more favorably treated than stock for assets
§ Here, there is a revenue ruling: If have assets after dust settles, will treat as stock for assets
·         Still, even this is not so clear:
o   What if liquidation was not contemplated at time of transaction?
o   What if liquidation was done 3 months later? 6 months? Year later? 
Basic Concepts of Income
·         What is income / calculation of

Worthless Securities
§ Security which becomes worthless shall be treated as a loss from the sale or exchange of a capital asset
§ Security =
·         Stock, bond, debenture, note payable
 
D.O.I. Income & The §108 Exclusion
The Available Exclusions and their Consequences
·         Under certain circumstances, delineated in §108(a)(1), DOI income is excluded from GI
o   The tradeoff for this favorable treatment is that the TP must give up certain favorable tax attributes, specified in §108(b)
·         §108(a): Exclusion from gross income
o   DOI is not included in GI if
§ The discharge occurs in a Title 11 case
§ Discharge occurs when the TP is insolvent
§ Indebtedness discharged is qualified farm indebtedness
§ TP other than a C corp, the indebtedness discharged is qualified real property business indebtedness
§ Indebtedness discharged is qualified principal residence indebtedness, discharged before January 1, 2013
o   “A Title 11 Case”
§ Defined as a case under Title 11 of the US Code (Bankruptcy). This could and does include different chapters of Title 11 – notably Chapters 7, 9, and 11.
§ Only applies if TP is under jurisdiction of the bankruptcy court, and discharge is granted by the court as part of a plan approved by the court
·         Does not matter if debtor has more assets than liabilities – that would be insolvency
o   “Occurs when TP is insolvent”
§ Defined as more liabilities than assets, regardless of whether or not declared under Title 11
§ Partial Insolvency: where the discharge of debt creates solvency in the debtor
·         Rule: the portion of the DOI income which creates solvency is included as GI under §61
·         Hypo:
o   Assets = 1,000