Double your tax returns, double your fun? Well, maybe taxes aren’t fun, but they are inevitable and mastering the gem of the short tax year can mark you as a bankruptcy lawyer who really knows his stuff.
The audio tape of the Advanced Tax program from the NACBA convention goes well beyond beyond the 3 year rule, 2 year rule, and 240 day rule, but the discussion of a short tax year was the one that stood out for me. It is too little understood and too seldom used. This must stop, I say<g>.
Probably stripped of its nuances, the concept is this: an individual debtor in a Chapter 7 or Chapter 11 can elect to have two tax years within a 12 month period. Internal Revenue Code 1398(d)(2). The first tax year ends the day before the filing; the second short year runs from filing to the year’s end.
Note that the short tax year election is available only in those bankruptcy chapters where the commencement of a case creates a new tax payer in the form of the bankruptcy estate. The trustee in a 7 or the debtor in possession in an 11 succeed to the debtor’s tax attributes and must file a tax return reporting any income the estate receives during administration.
Why would a tax payer elect to file two returns? I’ve used it in two situations. First, if the debtor is underwithheld or otherwise expects a tax for events in the pre bankruptcy portion of the year, and there are likely to be assets in the estate, filing a short year makes any liability in the first tax year a priority claim, payable from the assets of the estate. My attitude is that if my client is going to lose some asset, to the extent possible I want the proceeds to pay some debt he’d have to pay otherwise. Without the election, the debtor’s tax year will include all of the calendar year and the tax obligation is a post petition debt, payable from post petition earnings.
The second situation where electing a short tax year may be advantageous is where the debtor has tax attributes such as a loss carryforward or an unused tax credit as of the end of the prior tax year. Absent the short year election, those attributes as they existed at January 1 of the year of filing pass to the bankruptcy estate. Elect a short tax year, and the debtor can use them in the short year, and whatever is left after application in the short year, the trustee gets.
I don’t pretend to know if there are not other situations where the short year benefits the debtor. I have also learned that, while I preach that the inexperienced only take cases with less complex issues, we can’t always control the issue-set that people stroll in our doors carrying. You may see these fact patterns even while exercising care about not taking on more than you can understand and manage.
If you have an inkling that a short year election might provide your client with an advantage, send the client out for some input from a sophisticated tax professional; this is not a situation where H&R Block will do.
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