IRS Publication 908: Bankruptcy Tax Guide

Filing for bankruptcy introduces a unique and often confusing set of tax rules. The primary resource for navigating this complex area is IRS Publication 908, the “Bankruptcy Tax Guide.” This document provides the information necessary to understand the federal income tax consequences that arise when an individual or business seeks bankruptcy protection. The process creates specific obligations that differ significantly from routine tax situations, including the creation of a new taxable entity and special treatment for forgiven debts.

The Bankruptcy Estate and Tax Responsibilities

When an individual files for bankruptcy under Chapter 7 or Chapter 11, the law creates a new and separate taxable entity known as the bankruptcy estate. This estate legally consists of the property and assets the debtor owned at the time of the bankruptcy filing. The creation of this entity splits the tax responsibilities between the individual debtor and the estate itself.

The individual debtor remains responsible for filing their personal tax return and paying taxes on income earned before the bankruptcy filing date. They are also responsible for taxes on any income earned after the filing date that is not considered part of the estate, such as post-petition wages.

A bankruptcy trustee is appointed by the court to manage the estate’s assets and financial affairs. This includes the responsibility for filing tax returns for the bankruptcy estate and paying any taxes due from the estate’s income, which is generated by the estate’s assets.

Required Tax Filings During Bankruptcy

During a bankruptcy proceeding, specific tax filing requirements apply to both the individual debtor and the bankruptcy estate. The debtor must continue to file their annual personal income tax return, Form 1040 or 1040-SR, for the entire year in which the bankruptcy was filed. On this return, the debtor reports all income they received throughout the full calendar year but must not include income that belongs to the bankruptcy estate.

The primary tax responsibility of the bankruptcy trustee is to file a U.S. Income Tax Return for Estates and Trusts, Form 1041, for the bankruptcy estate. This return is required if the estate generates gross income that meets or exceeds a specific threshold set by the IRS for the tax year. The trustee must secure an Employer Identification Number (EIN) for the estate, as it is a separate entity for tax purposes, and can deduct administrative expenses like trustee and legal fees.

Tax Treatment of Canceled Debt

A significant aspect of bankruptcy is the treatment of canceled or discharged debt. Under general tax law, a lender forgiving a debt is often considered income to the borrower, which would typically be taxable. This “cancellation of debt” income would create a substantial tax liability for someone already in financial distress, undermining the relief that bankruptcy is intended to provide.

The tax code provides an exception for debts discharged in a Title 11 bankruptcy case. Debt that is canceled as part of a bankruptcy proceeding is specifically excluded from the debtor’s gross income. This means the individual does not have to report the amount of forgiven debt as taxable income on their Form 1040.

To claim this exclusion, the debtor must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness. This form is filed with the individual’s tax return for the year in which the debt cancellation occurs.

Handling Tax Attributes

While canceled debt in bankruptcy is not taxed as income, there is a corresponding requirement to reduce certain tax benefits, known as tax attributes. This reduction is the “cost” of excluding the discharged debt from income. The IRS requires debtors to reduce them by the amount of the canceled debt that was excluded from income.

Publication 908 specifies a strict order for reducing these attributes, and the process is detailed on Form 982. For example, if a debtor has $50,000 in canceled debt and a $10,000 NOL, the NOL would be completely eliminated, and the remaining $40,000 would be applied to the next attribute. The order of reduction is:

• Net Operating Loss (NOL) and NOL carryover
• General business credit carryover
• Minimum tax credit
• Capital loss and capital loss carryovers
• Basis of the debtor’s property
• Passive activity loss and credit carryovers
• Foreign tax credit carryover

Procedural Steps for Partnerships and Corporations

The tax procedures for partnerships and corporations undergoing bankruptcy differ from those for individuals. When a partnership or corporation files for bankruptcy, a separate bankruptcy estate is not created. The business entity itself continues its existence for tax purposes and remains responsible for its own tax obligations throughout the bankruptcy process.

Because no new entity is formed, the partnership or corporation continues to file its usual federal income tax returns. A partnership will file Form 1065, and a corporation will file Form 1120.

When a business entity’s debt is discharged in bankruptcy, the rules for excluding that debt from income are applied at the entity level. The partnership or corporation itself excludes the canceled debt from its income and files Form 982 to report this exclusion. The entity must then reduce its own tax attributes, following the same ordered rules that apply to individuals.