THE ESTATE OF AN INDIVIDUAL FAMILY FARMER AS A TAXABLE ENTITY: SECTION 1231(b) OF THE BANKRUPTCY CODE

(COMMISSION TRACK NUMBER 217)

Present Law

Section 1398 of the Internal Revenue Code provides certain rules for the taxation of estates of individuals in cases arising under chapter 7 or chapter 11 of the Bankruptcy Code (fn. 85). The estate is required to compute its taxable income in the same manner as an individual, and the tax liability computed with respect to such taxable income is to be paid by the trustee (fn. 86). Section 1398 provides detailed rules dealing with the taxable years of individual debtors who file bankruptcy petitions, rules dealing with the income, deductions and credits of the bankruptcy estate, and the transfer of tax attributes between a debtor and an estate. Significantly, section 1399 of the Internal Revenue Code provides that "[e]xcept in any case to which section 1398 applies, no separate taxable entity shall result from the commencement of a case under title 11 of the United States Code."

The effect of these rules, as they relate to individuals, is that when an individual files a chapter 7 or a chapter 11 case, a new taxable entity springs into existence for federal income tax purposes, as to which the trustee must file returns and pay tax. However, when such an individual files a case under chapter 12 or 13 of the Bankruptcy Code, no separate taxable entity is created for federal income tax purposes. The individual's return filing requirements are unaffected, and all items of income and deduction realized by the bankruptcy estate are reported on the returns of the individual debtor.

Various sections of the Bankruptcy Code provide rules for a bankruptcy estate's liability for state or local income taxes. With the exception of the treatment of chapter 12 estates, dealing with bankruptcies of family farmers, these largely parallel the federal rules, although the wording is not identical. For example, section 346(b)(1) of the Bankruptcy Code provides in part, "in a case under chapter 7, 12 or 11 of this title concerning an individual, any income of the estate may be taxed under a state or local law imposing a tax on or measured by income only to the estate, and may not be taxed to such individual" (fn. 87). Income in a chapter 13 case may be taxed only to the individual and not to the estate (fn. 88). The liability of such an estate for taxes in a chapter 7 case is buttressed by a provision which requires filing of state or local income tax returns by a trustee, but only if such estate "has net taxable income for the entire period after the order for relief under this chapter during which the case is pending" (fn. 89). Section 1231(b) of the Bankruptcy Code specifically provides that "the trustee shall make a state or local tax return of income for the estate of an individual debtor in a case under this chapter for each taxable period after the order for relief under this chapter during which the case is pending" (fn. 90).

Proposals Before the Commission

Commission Track Number 217. The Government Working Group proposes that section 1231(b) of the Bankruptcy Code be repealed. Government Working Group Proposal No. 9. See also Santa Fe Discussion Issues, p. 27, Item IVE7.

Task Force Position

The Task Force supports the Government Working Group's proposal.

Reasons for Position

Under both the Internal Revenue Code and the Bankruptcy Code, a separate taxable entity is created in a case concerning an individual debtor under chapter 7 or chapter 11. The same is not true in a case under chapter 13, presumably because of the fact that an individual's post-bankruptcy income is committed to the satisfaction of chapter 13debts. Therefore, the income during the period of bankruptcy administration is reported on an estate income tax return in individual chapter 7 and chapter 11 cases, but on the individual debtor's personal income tax return in chapter 13 cases. There is no proposal pending before the Commission to change these entity and return filing rules with respect to chapters 7, 11 and 13, and the Task Force does not itself propose any changes. Regardless of the merits, the current law has the advantage of symmetry between the federal and state/local tax treatment of bankruptcy estates.

The treatment of family farmer cases under chapter 12 is anomalous, and has no basis in logic. It probably results from oversight. Chapter 12 was not a part of the original Bankruptcy Code in 1978, and did not exist when the Bankruptcy Tax Act of 1980 was enacted. In 1986, chapter 12 was added to the Bankruptcy Code, setting up special rules for the administration of cases involving family farmers. Chapter 12 contains its own special state and local tax provisions, including section 1231(b). When chapter 12 was enacted, however, no effort was made to amend section 1398 of the Internal Revenue Code to include chapter 12 cases as situations in which separate taxable entities would be created. The Task Force does not know what the actual practice has been. However, if debtors in fact comply with the law as it stands, income of the estate is taxed to the individual family farmer for federal income tax purposes but to the trustee for state and local tax purposes. The Task Force cannot think of any argument supporting these inconsistent rules, and it is clear that one of them should be changed.

The Government Working Group proposes to abolish the requirement for filing state and local tax returns. If this is done, the rules for state and local income taxes would parallel those applicable to federal returns under section 1398 of the Internal Revenue Code. The choice of adopting the current federal rule rather than the current state rule appears to be the better one, based upon the fact that overall, the substantive provisions of chapter 12 are closer to those of chapter 13 than to chapters 7 and 11.

There are two other collateral technical amendments that are necessary. First, the reference to chapter 12 in sections 346(b)(1), 346(g)(1)(C) and 346(i)(1) should be deleted (fn. 91). Second, section 1231(a) should also be repealed (fn. 92).

Other Institutional Positions

The National Bankruptcy Conference is on record as supporting repeal of section 1231(b). A focus group of the American College of Bankruptcy takes the same position.

****************************FOOTNOTES*******************************

fn. 85: I.R.C. Section 1398(a). The rules provided by the section do not apply if a case, once having been commenced, is subsequently dismissed. I.R.C. Section 1398(b). In such case, presumably, the individual files the same returns and reports the same income as if the bankruptcy case had never been commenced.

fn. 86: I.R.C. Section 1398(c)(1). The tax rates are those applicable to married individuals filing separately. I.R.C. Section 1398(c)(2).

fn. 87: Bankruptcy Code Section 346(b)(1).

fn. 88: Bankruptcy Code Seciton 346(d).

fn. 89: Bankruptcy Code Seciton 728. 11 U.S.C. Seciton 1146 requires a chapter 11 return, but it is not limited to a situation in which there is net taxable income during the entire period of administration of the case.

fn. 90: Bankruptcy Code Section 1231(b).

fn. 91: The later sections deals with gain recognition and tax attribute carryovers when property is transferred between the estate and the debtor. Once separate entity classification is repealed, these provisions will become obsolete.

fn. 92: This section terminates the taxable year of an individual when a chapter 12 case is filed. Once separate entity classification is repealed, this provision will become obsolete.

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Last updated June 1, 1997