A tax loss carryforward in the hands of a bankruptcy trustee can have results as distressing as crayons in the hands of an unsupervised toddler. Identify the debtor’s tax attributes before you do your liquidation analysis.
Whether you are selecting a chapter for a client, working exemption issues, or calculating what a Chapter 13 plan has to pay, you are analyzing whether there is non exempt equity over and above the administrative expenses and costs of sale in assets. Among the expenses you need to consider is any tax consequence of the trustee’s liquidation.
Often, I see assets that appear to have equity, but once I’ve included the tax the trustee would pay on sale, the asset is safe in the hands of the debtor: any net sale proceeds would be consumed paying administrative taxes.
Your calculations can be perfectly correct and your reliance on just the tax basis and net sales price disastrous if the debtor has loss carryforwards that would shield the gain on the sale from tax. As a non tax expert, I understand the consequence to be this: if the debtor has losses of the same kind as the gains the transaction in question will generate, then the gains are not taxable up to the amount of the loss applicable under the IRC. [ I’m sure if that’s not a concise statement, someone will jump in to correct me].
The take away here is that the trustee acquired the debtor’s tax attributes as they exist on the day of filing. [ That’s why the short tax year election, which ends the day before the filing, is useful to position the debtor to use those attributes on the debtor’s short year return .) So the trustee takes the debtor’s basis in an asset and also succeeds to the loss carryforwards or unused tax credits. Those attributes may lessen the tax cost of liquidating an asset and make a property that, absent the tax attributes, would not be economic to sell suddenly much more desireable.
Again, you don’t have to be able to calculate the tax in such situations personally. You simply need to ask the questions of your client, or his tax professional, to determine the net tax cost of liquidation, before you make choices that are irreversible.
Image courtesy of woodleywonderworks.