A bankruptcy discharge has many effects and timing is important. The most well-known, of course, is that debts are eliminated and the debtor has no further obligation to pay them. A lesser-known consequence of bankruptcy can be its effect upon a debtor’s future income.
The income itself is not directly affected by a bankruptcy, but the tax upon income can be. This is because tax attributes generally must be reduced by the amount of the debt discharged.
Tax attributes include the following:
Taxpayers who itemize deductions often have one or more of these tax attributes, which are benefits when completing a tax return and trying to reduce taxable income.
Recently we had a discussion in my firm about when these tax attributes are reduced. My leading tax lawyer was adamant that the attributes are reduced the same year as the debtor files bankruptcy. He was relying upon IRS Form 982 and its instructions.
Form 982 is what debtors/taxpayers should file so that the tax authorities are aware that they have discharged debt in bankruptcy. This form is also used when debt is forgiven for any reason and the debtor wants to avoid being taxed upon that cancellation of debt income.
Back to the timing question. My position was that the debtor gets to take full advantage of any tax attributes for the year of the bankruptcy discharge before those attributes are reduced. This means that if the debtor still has available depreciation or a net operating loss carry forward, those attributes can be used to reduce the current year’s income before they are reduced because of the bankruptcy filing in this year.
I won the argument. Not because I am smarter or more experienced, but because I looked at the statute. Internal Revenue Code §108(b)(4)(a) provides that the “reductions shall be made after the determination of the tax imposed by this chapter for the taxable year of the discharge.”
After checking the statute, I verified my interpretation by consulting with some articles and papers written by tax experts with knowledge far beyond my own.
One of the first things I learned in law school, more than four decades ago, was to always start my research by looking at the statute. Judge Robert D. Martin, the bankruptcy judge before whom I practiced for about 35 years, many times expressed this same principle.
In this case, the statute tells us that tax attributes can be reduced after applying them for the tax return for the year of the bankruptcy discharge.