The Treasury Department’s computer-generated tax notices have increased over the last several years. At the same time, finding knowledgeable personnel at the IRS to discuss bankruptcy tax issues has become increasingly difficult. Knowing the source of potential issues goes a long way toward avoiding the pain they may cause. It is, therefore, important to know the rules, follow the rules as best as you can, and disclose in detail the specific circumstances of a bankruptcy when you cannot provide the information the IRS is seeking because it has not been made available to the trustee or does not exist.
Partnerships, S corporations, C corporations and LLCs
Business bankruptcies such as corporations, S corporations and partnerships continue their tax-reporting responsibilities after the petition date in the same manner as they did pre-petition. The filing of a bankruptcy petition does not create a new tax year or a separate entity for such debtors. That means the tax year remains the same and there is the potential that payroll tax returns (Forms 941, Form 940 and Forms W-2) may be required of the estate for a quarter or year ending during the trustee’s administration. It also means that the estate is expected to include certain of the debtor’s pre-petition accounting in the first annual tax return that will be filed by the trustee/debtor in possession (DIP) for the bankruptcy estate.
It is not unusual for the IRS to inform a trustee that federal payroll tax deposits were made pre-petition and there is a credit on the debtor’s payroll account. Such notices generally imply that a payroll tax return might not have been filed for a period before and/or after the petition date. On occasion, the Social Security Administration will advise that annual Forms W-2 do not match the same year’s Forms 941, Employer’s Quarterly Reports, implying that the W-2s were incorrect or might not have been filed at all. Ignoring payroll-related correspondence from the IRS generally triggers additional more aggressive notices and can also result in the assessment of significant civil penalties that can take many months and significant effort to eliminate.
Gathering copies of the debtor’s prior years’ income tax returns, payroll tax returns and, if possible, past and current payroll records when a trustee is first appointed can be crucial to avoiding a fight over unfiled payroll tax returns while trying to administer or close a case. If it is possible to obtain a debtor’s accounting records for the period immediately prior to the petition date, that information may also be very helpful, assuming such records are reasonably accurate. To the extent the debtor used a payroll-preparation service, enlisting that service’s assistance early in the case to wrap up annual payroll reporting and issue W-2s may well be worth the cost.
Without the information necessary to satisfy IRS requests for data or tax returns that remain unfiled, it is wise to respond in writing to any notices and to provide a detailed explanation of the circumstances to allow the IRS to understand the trustee’s lack of historical knowledge and documentation. On occasion, after several attempts it may be necessary to request the Taxpayer Advocate’s assistance in resolving the issue using Form 911.
In the absence of tax return copies, it may be helpful to request transcripts, a record of the debtor’s tax account and/or a Verification of Nonfiling using Form 4506-T. If the debtor is a single member LLC (SMLLC), it may be the only way to determine the type of entity the trustee is dealing with and what kind of income tax return may be required. The SMLLC debtor may be a disregarded entity without an annual tax-reporting requirement (because its annual financial activity is reported in the owner’s tax return) or may have elected to be treated as a corporation or an S corporation.
Obtaining “type of entity” information at the beginning of the case may avoid late-filing penalties that accrue monthly for pass-through entities such as partnerships or S corporations based on the number of partners or shareholders, respectively. As you can imagine, an entity with many partners or shareholders can accrue sizeable penalties in a short period of time. Over the past few years, the IRS has been reluctant to abate such penalties, and appeals will often not settle for less than 50% of the assessment, no matter the circumstances.
Individual Chapter 7 and Chapter 11 Estates
An individual chapter 7 or 11 bankruptcy filing creates a new taxpayer entity (the “individual estate”) on the petition date, with a tax filing requirement separate and apart from the individual debtor. For this reason, the individual estate must obtain a separate taxpayer identification number or possibly two, if the bankruptcy petition was filed jointly with a spouse.
An individual estate is not required to file an annual tax return unless annual income exceeds a threshold ($12,550 for 2021) and the tax return required is Form 1041, with an individual Form 1040 attachment that serves to calculate the tax. Individual estates are not required to pay alternative minimum tax (Form 6251) or net investment income tax (8960).
There are a number of special tax rules and unforeseen situations associated with individual estates, including, but not limited to, the following:
- The individual estate’s tax year is not limited to a calendar year. For this reason, the individual estate can choose to file an income tax return with a taxable year that is most advantageous when filing an initial tax return;
- The individual estate obtains the individual debtor’s nonexempt assets, including tax attributes (e.g., net operating loss carryovers, capital loss carryovers, credit carryovers, tax basis of assets, etc.) as of Jan. 1, of the year a petition is filed unless the debtor makes a 1398 election;
- When an individual debtor makes a 1398 election and elects to bifurcate his/her tax year into two periods (filing a tax return for the period before the petition date and one for the period that follows), tax attributes can be reduced before they become property of the bankruptcy estate. In addition, any unpaid tax liability reported on the individual debtor’s first short-period, pre-petition annual tax return becomes a claim in the bankruptcy estate;
- The individual estate’s interest in the debtor’s pass-through entities such as LLCs, partnerships, S corporations and certain trusts retain the debtor’s tax basis. It may be wise, then, to determine whether any such pass-through entities could subject the estate to phantom income, and related tax without cash to pay, by paying close attention to any negative capital accounts;
- Appreciated rental real estate with sizable, accumulated depreciation and minimal equity may trigger recaptured income (taxed at ordinary rates), and a large tax liability without the net proceeds to pay Uncle Sam; and
- To the extent an individual debtor owns a sole proprietorship with employees, payroll taxes and related payroll tax returns must be addressed to avoid significant penalties in the face of unpaid taxes and/or unfiled payroll tax returns or W-2s.
Gathering all available information at the beginning of a case, abandoning questionable assets, filing timely tax returns, and responding to IRS inquiries as quickly and thoroughly as possible with detailed disclosures will not eliminate all of an estate’s tax issues, but may go a long way toward shortening the time necessary to resolve issues. Clearly, the pandemic has strained the IRS’s already-limited resources and further increased the its use of automated, computer-generated notices and responses, exacerbating the problems in the overwhelmed system. Hopefully best practices and lots of patience will see us all through to a more efficient IRS soon.