PROPOSAL TO CREATE AN ELECTIVE SHORT TAXABLE YEAR FOR STATE AND LOCAL TAX PURPOSES

(COMMISSION TRACK NUMBER 217A)

Present Law

Section 1398 of the Internal Revenue Code creates a separate taxable estate when an individual files a petition in a chapter 7 or chapter 11 case (fn. 93). Section 1398(d) provides that as a general rule, an individual's taxable year does not terminate when such a petition is filed (fn. 94). However, section 1398(d)(2) provides that an individual may elect to terminate his taxable year as of the date prior to the filing of the bankruptcy case, thus starting a new taxable year on the day the petition is filed (fn. 95). This election is important, principally because it enables a debtor going into a chapter 7 or 11 bankruptcy to terminate his taxable year, thus creating a "prepetition" tax liability which, although nondischargeable, can be paid as a priority tax out of the assets of his bankruptcy estate (fn. 96). The draftsmen of the Bankruptcy Code were cognizant of the issues surrounding this provision, but addressed it in their own way. Section 728 of the Bankruptcy Code provides in part, "for purposes of any State or local law imposing a tax on or measured by income, the taxable period of a debtor that is an individual shall terminate on the date of the order for relief under this chapter [i.e., chapter 7], unless the case was converted under section 1112 or 1208 of this title" (fn. 97).

Proposals Before the Commission

Commission Track Number 217A. This proposal.

Task Force Position

The Task Force proposes that the Commission recommend amending sections 728(a), 1146(a) and 1231(a) of the Bankruptcy Code to conform with the Internal Revenue Code. Sections 728, 1146 and, if it is not otherwise repealed, section 1231 of the Bankruptcy Code, should be amended to provide that if the Internal Revenue Code gives a debtor an election to terminate his taxable year for federal income tax purposes, and the debtor, or the debtor's spouse in the case of a joint return, makes such an election, then the debtor's taxable year for state and local tax purposes shall terminate on the date of termination for federal income tax purposes.

Reasons for Position

There is no policy justification for having a different taxable year for federal purposes on the one hand, and for state and local purposes on the other hand. Most states use federal taxable income as a base for computing a state or local income tax liability, if any. This policy decision cannot be implemented if the taxable periods are different for federal, state and local income tax purposes. Yet, as the two statutes currently coexist, there will always be a different taxable year for federal income tax purposes and for state and local income tax purposes for the year in which an individual debtor files a bankruptcy case. If the debtor does not make the federal election under section 1398(d)(2) of the Internal Revenue Code, then he will have a full taxable period of twelve months for federal income tax purposes, but will have two taxable years for state and local income tax purposes as a result of the special tax provisions now contained in chapters 7, 11 and 12. Moreover, because of differences in drafting, there will be a variance of a single day in such taxable periods even if the debtor does make the federal election. Under section 1398 of the Internal Revenue Code, the debtor's first short taxable year would end on the day before the petition is filed, whereas under the special tax provisions of the Bankruptcy Code, the first short taxable year ends on the date of filing the petition. The interest in uniformity clearly outweighs any argument that can be made for retention of present law,although the Task Force does not know of any such argument.

Other Institutional Positions

The National Bankruptcy Conference is on record in supporting this amendment.

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

fn. 93: I.R.C. Section 1398(c).

fn. 94: I.R.C. Section 1398(d)(1).

fn. 95: I.R.C. Section 1398(d)(2). This section also contains special rules coordinating the taxable years of nonbankrupt spouses to enable such spouses to file joint returns. I.R.C. Section 1398(d)(2)(B).

fn. 96: This election also tolerates some more sophisticated tax planning on the debtor's part. If the individual would have a loss for the portion of the year prior to the filing of the bankruptcy peition he can refuse to make the election, thus using the loss in the second part of the year against his postpetition income, which would be reported on a normal full year tax return.

fn. 97: Bankruptcy Code Section 728(a). Identical provisions apply to individual cases under Chapters 11 and 12. See Bankruptcy Code Sections 1146(a) and 1231(a).

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Last updated June 1, 1997