Report of the American Bar Association Tax Section Task Force on the Tax Recommendations of the National Bankruptcy Review Commission

ABANDONMENT

(COMMISSION TRACK NUMBER 425)

Present Law

Section 554(a) of the Bankruptcy Code provides in part "after notice and a hearing, the Trustee may abandon any property of the Estate that is burdensome to the Estate or that is of inconsequential value and benefit to the Estate."

Section 1398(f)(1) of the Internal Revenue Code provides that the transfer of an asset by a debtor to the bankruptcy estate is not treated as a disposition. It does not appear to be relevant to the discussion. Neither the Commission nor the Task Force proposes any change to it.

Section 1398(f)(2) of the Internal Revenue Code provides:

Transfer from estate to debtor not treated as disposition. In the case of termination of the estate, a transfer (other than by sale or exchange) of an asset from the estate to the debtor shall not be treated as a disposition for purposes of any provision of this title assigning tax consequences to a disposition, and the debtor shall be treated as the estate would be treated with respect to such asset.

The two sections are meant to mirror each other so that there is no taxable event upon assets going to the estate from the debtor nor, at the termination of the estate, from the estate to the debtor. Section 1398(f)(2) does not contemplate an abandonment by the trustee at some point in the proceedings prior to the termination.

Commissioner Shepard's proposal would overrule In re A. J. Lane & Co., Inc., 133 B.R. 264 (Bankr. D. Mass. 1991), In re Rubin, 154 B.R. 897 (Bankr. D. Md. 1992), and In re Matson, No. 90-42308-7 (Bankr. D. Kan. Dec. 12, 1991). These cases hold that a postpetition tax which would be incurred after the abandonment of property from the estate would impair the debtor's fresh start and that under those circumstances the trustee should not be permitted to abandon the asset. The proposal cites other cases taking a contrary position.

Proposals Before the Commission

Commission Track Number 425. Commissioner Shepard proposes an amendment that would provide specifically that the abandonment is not a taxable event. See Santa Fe Discussion Issues, p. 3, Item IC1.

Task Force Position

The Task Force opposes this proposal. The Task Force instead proposes that Internal Revenue Code Section 1398(f)(2) be amended to provide that in the event that an asset is abandoned by the trustee to the debtor (whether at the termination of the proceedings or before), which asset at the time of the abandonment is subject to debt in excess of the basis of such asset, the debtor will be deemed to have disposed of the asset immediately before the filing of bankruptcy and the liability for the tax on disposition shall be a nondischargeable debt of the estate. The tax would be treated as a prepetition tax and would have the same priority as any other prepetition tax. To the extent that the liability attributable to such gain is not satisfied, then the debtor shall be liable for the balance of the tax due, such liability shall be due upon the actual disposition of the asset, whether by foreclosure or otherwise.

Reasons for Position

The issue of abandonment tax consequences are limited to individual bankruptcies under Chapter 7 and Chapter 11 because, unlike corporations and partnerships, the filing of bankruptcy by an individual creates a new person: the bankruptcy estate. See I.R.C Section 1398(a) (fn. 169).

Commissioner Shepard argues that "the position of these cases [A. J. Lane & Co., Inc. et al] seems illogical in light of the identification of taxes generally incurred within three years of bankruptcy as being nondischargeable. See, 11 U.S.C Section 507(a)(8)(A)." The Task Force has trouble with this reasoning,inasmuch as, under current law, no tax will have been incurred prior to the bankruptcy by the individual with respect to the property abandoned by the Trustee. The time a tax would be incurred would be upon a disposition by the debtor after abandonment by the estate.

Commissioner Shepard goes on to say that "the taxable abandonment is not the answer; whatever tax relief is the answer it must be specifically provided in the Code. Much of the abandonment problem is tax shelter oriented, is it desirable to extend relief in these cases?" With respect to the latter observation, for all practical purposes, there have been no significant real estate tax shelters created since the Tax Reform Act of 1986. However, there are many instances where a debtor will have property which has debt which is significantly in excess of both the basis of the property and its fair market value. Thus, upon a disposition of that property, tax will be imposed upon phantom income, that is, income will be realized but there will be no cash realized.

It should also be kept in mind that the bankruptcy estate succeeds to the debtor's tax attributes, including net operating loss carryforwards and capital loss carryforwards. These items could be used to offset the phantom income, in whole or in part. If the estate uses those attributes and still abandons the asset, then the debtor does not have those attributes to make a similar offset. The creditors often will also get to keep any tax refunds to which the debtor is entitled for the one, two or even three years preceding the commencement of the case. Those refunds are generated in part, if not whole by the same depreciation deductions which reduce the basis of the property in question and thereby create the potential tax liability. Again, the creditors get the benefit of the tax deductions but the debtor is forced to accept the continuing tax liability with which the benefit is associated. Thus, the position advanced by Commissioner Shepard results in a windfall to the creditors. The position advanced by the Task Force puts the creditors in no worse position than they would be in had the debtor actually disposed of the property prior to the filing of bankruptcy.

The tax controversy concerns the abandonment of property which is subject to a nonrecourse lien substantially in excess of its tax basis and also in excess of its fair market value (or only marginally less than its fair market value). In a real economic sense, such property is a liability, not an asset and, as a matter of policy, should be treated as a liability, and not an asset, for purposes of both the bankruptcy law and the tax law. There is no justifiable reason to treat it different from any other liability. This line of reasoning would support a position endorsing the A. J. Lane & Co., Inc. result.

The A. J. Lane position would allow a debtor to impose on creditors the entire tax liability, cramming down in toto the fresh start concept on them. The Task Force does not, however, follow that position. The Task Force believes that the more equitable result would be obtained by amending Section 1398(f)(2) to provide that upon abandonment by the trustee of an asset which is subject to debt in excess of the basis in the asset, the asset will be deemed to have been disposed of immediately before the filing of bankruptcy. In the event of abandonment by the trustee, the tax on the gain would be treated as a prepetition tax, having the same priority as any other prepetition tax. No interest would accrue on the deferred tax liability, and none should because there has been no actual disposition.

An example of how the proposal would be applied is as follows:

The asset has a basis of $300 and a debt of $1000. The debtor has a loss carry forward of $200 at the time of filing. At the time of the abandonment, the estate has a gain of $700, $200 of which is offset by the loss carry forward. The estate has to pay tax on $500. Assume the tax is $140 and the estate can only pay $60. The debtor will be liable for the balance, $80, in the year of disposition. That amount would be adjusted based on an actual determination of the amount realized on disposition. A statement as to the deferred liability would be included in each return of the debtor until the year of disposition.

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fn. 169: For bankruptcy purposes, however, a separate estate is created whether the Debtor is an individual, partnership or a corporation. Bankruptcy Code. Section 541(a).

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