When an individual files for a Chapter 7 or Chapter 11 bankruptcy, they create an entirely separate taxable entity known as the bankruptcy estate. This estate consists of assets owned by the individual prior to filing bankruptcy and is usually managed by a court appointed trustee or fiduciary. The bankruptcy estate comes into existence the day when the bankruptcy proceedings commence. Between the time the proceedings are initiated and the time they are completed, the bankruptcy estate may generate income and expenses. Income tax is imposed on the bankruptcy estate if it has taxable income after deducting its expenses and its standard deductions.
What Happens If the Bankruptcy Petition Does Not Get Approved by the Courts?
If the bankruptcy petition does not get approved, then no bankruptcy estate is created. However, a petitioner can appeal an unfavorable ruling by a bankruptcy judge. These appeals are made in district court. It is worth noting that depending on where the appeal is filed, it may be heard by an established panel of three judges. If the petitioner is unhappy with initial appeal, they can then filed with the appropriate court of appeals.
What Does “Separate Taxable Entity” Mean?
Filing for bankruptcy creates a bankruptcy estate that will have unique:
- Tax liabilities
- Tax return filing responsibilities
Usually, the trustee or the fiduciary will be responsible for the tax filing requirements for the bankruptcy estate.
How Is Income Tax for a Bankruptcy Estate Calculated?
Income tax calculation for a bankruptcy estate is the same as the calculation for an individual taxpayer. One of the biggest difference is that a bankruptcy estate can only use the standard deduction for a married individual filing a separate return.
Does the Home Sale Exclusion Apply to a Bankruptcy Estate?
Yes. A bankruptcy estate selling a qualified principal residence will enjoy the same home sale exclusion as an individual taxpayer would. Thus, if the bankruptcy estate needs to sell an appreciated home in order to settle its liabilities, it will be entitled to exclude part of the resulting gain from tax if the home qualifies as a principal residence.
Note that transfers of property between the bankruptcy estate and the bankrupt individual are not subject to tax.
What Happens If the Bankruptcy Estate Has a Net Loss?
When the expenses of the bankruptcy estate exceed the income that it generates, the loss is called "excessive administrative cost." An excessive administrative cost may be carried back to offset income of the bankruptcy estate in prior tax years, if it exists, and the income of the bankrupt individual in the year prior to the bankruptcy proceedings.
Do I Need an Attorney to Help with Tax Issues?
Tax laws are complex and ever-changing. Although there are various tax preparation programs on the market, none can provide the same level of service that an experienced and knowledgeable bankruptcy attorney can. This is particularly true with respect to bankruptcy claims. If you are filing for bankruptcy, are seeking to discharge a debt, are unsure about your tax responsibilities or you need someone to represent you in a bankruptcy court or before the IRS, a tax lawyer can help.