The Tax Gotcha When Debt Settled Outside of Bankruptcy

4226218448_849b2121b0_zAll manners of avoiding tax on cancelled debt are NOT created equal.

I have, up to this point, treated “discharge in a case under Title 11” and “insolvency” as equally effective ways to avoid including cancelled debt in taxable income.

Thirty five years into this practice, I just discovered that there is a world of difference in the long run, after an encounter with a diligent, but ultimately incorrect, tax preparer for a Chapter 13 client.

The issue was whether the debtor must reduce the basis on his home by the amount of debt discharged in his bankruptcy.

In my case the unsecured debt was a whopping $375,000.  The preparer insisted that the client must reduce his basis by that amount upon discharge of the debt in Chapter 13.

That would have effectively eliminated the basis in the home, for purposes of someday calculating capital gain on a sale.  The client was horrified.

IRS Form 982

We’ve all pointed clients who call up clutching a 1099 for cancelled debt to  form 982.  It’s the reply, if you will, to the 1099.

The taxpayer gets to say, yes, this debt was cancelled but it isn’t taxable income because….  There follow the boxes for the applicable reasons that it isn’t includible in income.

Top of the list is bankruptcy.  Second is insolvency.

That’s Part I of the form.

Part II goes on to tell the taxpayer to reduce various tax attributes, like credits, loss carryforwards and basis, by the amount of the debt forgiven.

Line 10a tells you to reduce the basis of non depreciable property.  That, my friends, includes homes.  Ouch.

That line had my client in a panic, as he contemplated a zero basis for his home.

Keep reading

The saving grace, it turns out, is found in IRC 1017(c), which I discovered only after some help from my friends on the NACBA listserve.  This section governs the adjustment of tax attributes when debt is forgiven.

A “special rule” in subsection (c) provides that there is no reduction in basis on assets claimed exempt in a bankruptcy proceeding if the forgiven debt is excluded by reason of bankruptcy.

Whew!  My client’s exempt home, and his historic basis in it, takes no tax hit as a result of his bankruptcy discharge.

Lessons garnered

The first lesson I took away, after the adrenaline rush subsided, is that claiming even underwater property exempt is worthwhile.  The real estate market has turned in many parts of the area I draw from, and today’s underwater house is tomorrow’s gold mine, it seems.

The second lesson applies to comparing the tax consequences of settling debt outside of bankruptcy versus getting a bankruptcy discharge of that debt.

I have been wont to say that the insolvency provision for excluding debt keeps most clients contemplating trying to negotiate debts away from ugly tax consequences.  [ Make sure that the client is really insolvent, by the formula used on Form 982, however.]

But that’s not so for homeowners.  Settle your debts outside bankruptcy when you are insolvent, and you are expected to reduce the basis in your home and, in effect, encounter the tax when you sell the home.

Chalk up another signal advantage for addressing debts in bankruptcy.

Image courtesy of Flickr and Antony Theobald. 


All You Need To Know To Help Clients With Tax Troubles

TaxesEverything you need to know about taxes in bankruptcy, plus a bit more, in a virtual workshop.

This NACBA webinar  November 20 and 21st will do far more than scratch the surface of the possibilities and pitfalls when your bankruptcy clients bring tax troubles to the table.

Plus, splitting the six hours of material over two days allows for a bit of law practice on the side.

What’s on tap

Day one opens with 2 hours of tax basics, including discharging taxes, tax liens, and planning for tax issues, along with the vital question of how to get and understand tax transcripts.

Next up is cancellation of debt income, capital gains, real and phantom, from sales of real property, and dealing with 1099’s.

Day two tackles liens and levies; the possibilites in the short year election; and innocent spouse issues. Tara Twomey looks at cases on SFR’s, plan provisions, and late filed returns.

The seminar wraps up looking at alternatives to bankruptcy for tax issues, including offers in compromise.

There’s a question and answer session with each speaker, if you attend live, and an opportunity to submit questions in advance.

Why add taxes to your bankruptcy practice

Competence in tax matters greatly expands the world of clients you can help in bankruptcy.  Every tax professional in your community has a network of people who could use bankruptcy to climb out of a tax hole.

Plus, there’s nothing like a tax collector threatening a levy to get the procrastinating potential client focused on fixing the problem.

It’s as though the tax folks are out beating the bushes for people who really need what I do.

Nuts and bolts

Webinar costs $199 for NACBA members; $349 for non members.

Webinar is live November 20 and 21 starting at noon Eastern time each day.

Sign up here.

CLE granted for IL and TX;  applied for in AL, CA, GA, KY, MN, NC TN, and WA.

Modest cost, delivered to your computer monitor, recorded if you have commitments keeping you from the live presentation.

Image courtesy of DonkeyHotey

When Laws Collide, You Need The Right Word

As lawyers, words are our stock in trade.

If we want to describe, explain, or persuade, we need to use the right word.

The difference between the almost right word and the right word is really a large matter – ’tis the difference between the lightning-bug and the lightning.  MARK TWAIN

I was blown away by the casual simplicity and clarity of Ed Boltz’s explanation of the difference between preemption and preclusion in an exchange  that just flew by on the NACBA list serve.  (You are a member of NACBA, aren’t you?)


Ed Boltz, NC Bankruptcy Lawyer

Ed has kindly permitted me to share here his charge to use the right word.

The discussion was originally about the 11th Circuit’s decision in Crawford v. LVNV, permitting FDCPA remedies for asserting of a stale claim in Crawford’s bankruptcy case. 

Take it away, Ed.

Choose your words carefully

It is vital to use terminology precisely, especially as different words cause different results to occur:

Preemption is when federal law supersedes or displaces state  law.

This can be partial or field preemption, express or implied, each with different criteria.

It occurs because the Supremacy Clause gives greater dignity (again a term with specific meaning) to federal laws than state or local.

Federal laws cannot preempt other federal laws, because they are of equal dignity.

Preclusion, however, is a means of resolving when federal laws conflict.

This can be express, for example, if one statute said that other statutes don’t apply. The Bankruptcy Code is replete with examples, i.e. amounts that would normally be collectible under the Tax Code are stayed and even dischargeable.

Preclusion can also be implied, for example where one statute does so much on a topic in certain circumstances  that other can’t function.  But here, a court must try to allow both statutes to function and to harmonize their goals and processes.

Preclusion at work

This is what most bankruptcy judges mean when they hold that the FDCPA is inapplicable to the bankruptcy claims process.  But when you read these holdings,  the courts aren’t usually deciding that the complained-of violation,  whether collecting on a stale debt,  not sending proper disclaimers, contacting represented consumers, is permitted.  The debts where the Statute of Limitations has run are disallowed.  Calls have to go through counsel.

What the judges do not want, however, is to be forced to give $1000 in statutory damages and attorneys fee, especially without any discretion.  That is the rub and it chafes, just as the lack of discretion in BAPCPA.  Judges want to judge, not be told by Congress how to run a calculator.

The problem for judges is, however, that Congress does get to tell them what to do.  So when the FDCPA determines (not arbitrarily, but for the very sound reason that absent the sting from statutory damages, creditors will not comply) that an attempt to collect a stale debt is worth $1000 plus actual damages, the bankruptcy judge has to ask whether that discretionless  award would utterly frustrate the purposes and processes of bankruptcy.

The question is not whether the Bankruptcy Code and Rules are sufficient to handle claims,  but whether the FDCPA is incompatible.

Picking Your Chapter 11 Teammates

9420983815_4857d1981b_zProfessionals in Chapter 11 have to be “disinterested“;  make sure they are also capable.

In two recent cases, the estate has employed professionals connected to the debtor in his pre filing past. It’s often the case that accountants and tax preparers come with familiarity with the debtor that seems useful.

You think that it’s economic to exploit that back story.

However, in the cases I’m recalling, the very history that made them appealing to the DIP has made it hard for the estate’s counsel to demand better performance than they have initially proffered.

Chapter 11 not for the newbie

I don’t talk much here about Chapter 11 issues.  Chapter 11 isn’t a big part of my practice and Bankruptcy Mastery is really for the less experienced bankruptcy practitioners.

I’m sure I’ve said it in print as well as in person:  a Chapter 11 is not an overgrown Chapter 13.

So if you are new to bankruptcy practice, stash today’s piece away til you are really ready to mastermind a Chapter 11.

No job for friends

When you represent the debtor in a Chapter 11, your client is actually the bankruptcy estate; the debtor in possession owes his loyalty to the creditors as a whole.

The DIP ends up in an uncomfortable spot if professionals of the estate were selected because of friendship,  perceived obligation, or the desire to do a good turn for a business buddy.

It developed for me, in a case I subbed into, that the professional, whose engagement had already been approved by the court, was delivering performance that was suspect.

The DIP sensed it, but was unwilling to call his friend on the issue.

In Chapter 11, a lot of the usual rules of business have changed.  Decisions outside of the ordinary are subject to notice to creditors;  dual loyalties that might pass outside of bankruptcy are unacceptable for professionals of the estate.  The professional with preexisting ties to the DIP may not get it, and the DIP may not have the gumption to call his buddy on it.

Competence first

It happens most often with accountants, in my experience:  the existing tax preparer knows the debtor, the way the books have been kept, the issues the debtor has faced.

It seems easier to employ someone who doesn’t have to start from scratch to do tax returns, tax planning and MOR’s.

Before the estate employs the existing accountant, I’ve got two questions.

First,  to what extent is the accountant complicit in whatever got the debtor into financial trouble?  If you are representing the DIP, you need to assess whether this professional was part of the problem, and whether the job, done properly going forward, will uncover things the accountant would rather not have exposed.

Second question:  is the existing professional up to the issues present in bankruptcy?  Bankruptcy adds complexity to every professional’s job.  My experience is confined largely to Chapter 11’s for individuals, and I remain bowled over by the bankruptcy tax issues that even capable tax professionals have never encountered.

My knowledge is confined to seeing the tax question.  It’s no fun when your fellow estate professional can’t see the question, much less help you find the answer.

Moral of the story:  it’s not sufficient to be “disinterested” within the meaning of the Code.  Estate professionals also have to be the right person for the job.

Image courtesy of  Simplificamos Su Trabajo

When Chapter 13 Debtors Run Amok

8632883494_62b7ddd71f_zWe’ve had a string of them….

[Hint: in a small practice, a “string” means “three. ” ]

But three clients in the past month with confirmed Chapter 13 plans have contracted to sell their homes without mentioning it to us, their attorneys.

The degree of chaos varied:  inadequate time to get approval of the sale from the trustee within the contractual closing date;  mortgage stripping issues when the plan is paid off early; and taxing authorities who decided to claim the post petition appreciation.

But the bigger problem is clear:  operating successfully in Chapter 13 requires debtors to absorb a bunch of information about how bankruptcy works.

  • What can they, and can’t they, do without prior consent?
  • What does the vesting option mean in the real world?

When is the best time to learn?

When we first meet prospective debtors, we’re dealing with people experiencing stress, shame, and overload.

Clients are overwhelmed with the information they must process on bankruptcy choices, procedure, and consequences.

When the case is confirmed, and all the client has to do (they think) is make the plan payments, they relax and tune out.

Yet we find clients borrowing money without the trustee’s consent; signing car contracts without considering their Chapter 13 plan; and selling stock to make ends meet.

If the only issue is covering our behinds, as professionals, we can write all the do’s and don’ts down, hand the client the tome, and get a receipt for its delivery.

That solves my problem, but isn’t likely to assure that the client reads, absorbs and recalls the admonitions when an issue arises a couple of years down the road.  The client who screws up is unlikely to be comforted by the fact I clearly told him what the rules were.

And the client who is injured by transgressing is likely to be resentful, at best, and vocal at worst, about the quality of the representation that he got.

Let’s trade fixes

What I learned from this string of fiascoes is that I need to deliver the “living in Chapter 13” commandments, in writing, after confirmation of the plan.  That doesn’t assure they get read or followed, but it ups the odds.

I can see a web page on the firm’s site, reciting the rules.

Maybe an instruction in our Chapter 13 representation agreement should reinforce the “ask first” directive.

How do you deliver this kind of information to clients?  What works better than others?

I’ve shared my train wrecks- it’s your turn to share solutions.

Image courtesy of Flickr and Shoji.k

One Trait Makes A Bankruptcy Lawyer Great

8677091677_b76c713b76_z (1)

One trait makes a bankruptcy lawyers  stand out.

Bankruptcy forms suck you in to the view that filing a case is just recording what the debtor owns and owes today.  If all you focus on is the here and now, you can assemble a bankruptcy petition.

But if there is one, uniform failing in average bankruptcy lawyers, it’s that they confine their attention to the here and now-what does the client have, owe, and earn.

Great bankruptcy lawyers take the broad view.  They look backwards and forwards from the filing date before uploading the petition.  Because bankruptcy rights and consequences flow from both the past and the future.

Let me count the ways this works.

Past events impact today’s petition

Our client’s present circumstances didn’t just pop up, overnight, like a mushroom.  They are the product of years of interlayered events.  The better we understand those events, the better we can advise the debtor.

  1. Means test income and Lanning :  does the 6 month look back income include a unique event, like a bonus, that won’t occur again?
  2. Preferences:  in the last 90 days, did they settle a suit, pay their student loans, make any transfer they don’t want undone?
  3. Transfers to insiders in the last year-  if client has been repaying family loans, you don’t want them surprised when trustee sues their parents
  4. Conveyances to “protect” assets– move title from debtor to buddy, and debtor may have set buddy up for suit and imperiled their discharge
  5. Contributions to 529 accounts  – money contributed to government sanctioned college savings accounts within two years may be recoverable by trustee
  6. Interstate moves–  a move between states within two years of filing may drive exemption options
  7. Fraudulent transfers under state law –  the statute of limitations on fraudulent transfers where I practice is four years, and the trustee assumes the creditor’s rights to recover the transfer
  8. Tax filings- if there’s tax debt, it matters whether client got an extension of time to file return and whether tax day fell on the 15th, 16th, or 17th three years ago
  9. Transfers with intent to hinder, delay or defraud within 10 years  522(0) provides for reduction of homestead exemption for bad acts within a decade

So, you may have to get the client’s life story to see all the issues in their bankruptcy filing.

Events after filing matter, too

We’d like to think that things are locked down, right and tight, when the case is filed.  But some post petition events will augment the property of the estate in ways that don’t benefit the client.

  1. Inheritances–  541 expands the scope of property of the estate to assets acquired by testate or intestate succession.  Did you inquire about the health of client’s relatives and their succession instrument of choice?
  2. Additional debts if it’s likely that the debtor will accrue more debts, perhaps from ongoing illness, those debts won’t be dischargeable for years if you file a Chapter 7 prematurely
  3. Mortgage payment adjustments coming  a mortgage payment reset may affect the means test and the money available to fund a Chapter 13.
  4. Real estate appreciation  post petition appreciation belongs to the estate.  In a rising real estate market, you may need to compel abandonment of property before it becomes attractive to the trustee
  5. Tax refunds – a fraction of any tax refund for the year of filing may belong to the estate.  If the client is overwithheld, did you advise reducing withholding to eliminate refund come April?
  6. Expiration of limitations on sale  when prepetition options vest, or restrictions on sale of stock expire, the trustee may be able to sell something previously worthless.

It’s not just filling out forms

The attorneys who see bankruptcy as “just filling out forms” set their clients up for unpleasant surprises.  It’s not easy or quick to extract all this information from a client who is stressed and self condemning.

Not easy, but the difference between adequate and great.

If you’re reading here, I’d like to think you’re a member of the Lake Wobegon Bar Association, where all the lawyers are above average.  Cheers.

Image courtesy of Flickr and Kim Seng

What Keeps Me Busy

empty chairsThe number of new cases through my doors is down, just like it is everywhere.

But I’m staying busy.   Busier some days than I would like to be.

I thought it might be fun to look at the change in the composition of my cases over the past two years.

More complicated cases

There don’t seem to be any simple cases anymore.  Debtors who have managed to avoid filing bankruptcy til this late in the Great Recession don’t lead simple lives.  Their issues are more complicated, the competing interests are stronger.

Complex cases take more of my time and support a larger fee.

Bankruptcy litigation

I’ve just completed the liability phase of a nondischargeability case, defending a debtor from charges that his moonlighting in the same field as his employer created a non dischargeable debt.

While bankruptcy litigation is down along with filings, there always seem to be more need for good bankruptcy trial lawyers than there is supply.

There are certainly more discharge violations than are ever enforced for the benefit of our clients.  Go on, make that discharge mean something.

Mortgage servicing complaints

For all the attention that mortgage servicing has gotten lately, it doesn’t seem to have gotten any better.  I’m finding that in or out of bankruptcy, homeowners have issues with the servicing on their loans.

And, praise be, we have some new tools to help homeowners in the beefed up procedures for getting information from the servicers.

I’m just getting back the first wave of responses to my requests for information on behalf of clients.  It remains to be seen whether the fixes will be administrative or litigation driven.

It’s clear to me that there is a need for accountability in the servicing world.

Bankruptcy intersects family law

The family law bar feeds me cases as fast as I can digest them.  Most families are fairly financially precarious when intact.  The same income can seldom support two separate households.  Bankruptcy can at least start the former spouses out with less economic baggage.

Yesterday’s new case involved the rights of a family lawyer against the other spouse in that spouse’s bankruptcy case.  The family court awarded the lawyers a lien on the community’s share of a partnership holding a commercial building.  My task will be to figure out the extent which that lien is enforceable in a Chapter 7 case.

Housekeeping deferred

So far, my days have been busy without resorting to cleaning my office or updating my client handouts.

How about you?  What’s keeping you busy?


Image courtesy of Flickr and John Haslam.