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Bankruptcy &

Insolvency Taxation

Third Edition

Grant W. Newton

Robert Liquerman

JOHN WILEY & SONS, INC.

BANKRUPTCY &

INSOLVENCY TAXATION

Third Edition

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Bankruptcy &

Insolvency Taxation

Third Edition

Grant W. Newton

Robert Liquerman

JOHN WILEY & SONS, INC.

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ISBN-13: 978-0-471-22808-0

ISBN-10: 0-471-22808-7

Library of Congress Cataloging-in-Publication Data:

Newton, Grant W.

Bankruptcy and insolvency taxation / Grant W. Newton, Robert Liquerman.--

3rd ed.

p. cm.

Includes index.

ISBN-10: 0-471-22808-7 (cloth : alk. paper)

ISBN-13: 978-0-471-22808-0

1. Bankruptcy--Taxation--United States. I. Liquerman, Robert. II. Title.

KF6332.N49 2005

346.7305'2--dc22

2004025813

Printed in the United States of America

10 9 8 7 6 5 4 3 2 1

n v n

About the Authors

Grant W. Newton, Professor of Accounting, Graziadio School of Business and

Management, Pepperdine University, Malibu, California, is the author of Bank￾ruptcy and Insolvency Accounting; Practice and Procedure (updated annually) and

Corporate Bankruptcy (2003), also published by John Wiley & Sons. He is the

Executive Director of the Association of Insolvency and Restructuring Advisors

and he developed and teaches the three courses that lead to the Certified Insol￾vency and Restructuring Advisor (CIRA) designation. A CPA, CIRA, and CMA,

he received a Ph.D. from New York University, a Master’s degree from the Uni￾versity of Alabama, and a B.S. Degree from the University of North Alabama.

Dr. Newton was a member of the AICPA’s Task Force on Financial Report￾ing by Entities in Reorganization Under the Bankruptcy Code that resulted in

the issuance of the Statement of Position 90-7. He is coauthor of Consulting Ser￾vices Practice Aid 02-1: Business Valuation in Bankruptcy and Providing Bankruptcy

& Reorganization Services—Practice Aid, both published by the AICPA. He serves

as a consultant and expert witness on issues dealing with financial reporting

during and emerging from chapter 11, valuation, terms of plan, tax impact of

plan, tax issues related to the bankruptcy estate, and recovery of assets.

Robert Liquerman is a principal in KPMG LLP’s Washington National Tax Prac￾tice, Corporate Tax Group, specializing in matters under Subchapter C of the

Internal Revenue Code. He is an adjunct professor of law in the LL.M. program

at the Georgetown University Law Center and previously served as an adjunct

professor in the LL.M. program at The College of William & Mary, Marshall￾Wythe School of Law. Mr. Liquerman holds an LL.M. in Taxation from New

York University School of Law; a J.D. from St. John’s University, School of Law;

and a B.S. in Accounting from the State University of New York at Binghamton.

He joined KPMG LLP from the Internal Revenue Service Office of the Chief

Counsel, Corporate Division. In this position, he drafted treasury regulations,

private letter rulings, technical advice memoranda, closing agreements,

responses to congressional inquiries, field service advice, and memoranda of

law. Prior to his government experience, Mr. Liquerman was a senior tax associ￾ate in the mergers and acquisition group and the insurance group in the New

York office of Coopers & Lybrand.

He is a frequent speaker on bankruptcy and tax issues at various tax insti￾tutes and conferences around the country, including Tax Executives Institute,

Federal Bar Association, DC Bar Association, and the Association of Insolvency

and Restructuring Accountants. Mr. Liquerman is a member of the American

Bar Association, Section of Taxation.

Although Chapters 2, 5, 6, and 7 reflect the views of Robert Liquerman, they

do not necessarily reflect the views of KPMG, LLP.

n vi n

IMPORTANT NOTE

As we go to press, Congress is on the verge of passing new legislation that

will affect corporate bankruptcy. Please email Sheck Cho at John Wiley &

Sons ([email protected]) to receive information about this new Act.

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Please phone 1-877-762-2974 or email us at [email protected] to

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we have already recorded your subscription for this update service.

n vii n

Contents

Preface xi

Chapter One

Nature of Bankruptcy & Insolvency Proceedings 1

1.1 Objectives 1

1.2 Alternatives Available to a Financially Troubled Business 3

Chapter Two

Discharge of Indebtedness 21

2.1 Introduction 23

2.2 Discharge of Indebtedness Income 23

2.3 Determination of Discharge of Indebtedness Income 24

2.4 Section 108(e) Additions to Discharge of Indebtedness Income 35

2.5 Section 108(e) Subtractions from Discharge of Indebtedness Income 53

2.6 Discharge of Indebtedness Income Exclusions 57

2.7 Consequences of Qualifying for Section 108(A) Exclusions 66

2.8 Use of Property to Cancel Debt 85

2.9 Consolidated Tax Return Treatment 95

2.10 Discharge of Indebtedness Reporting Requirements 112

Chapter Three

Partnerships and S Corporations: Tax Impact

of Workouts and Bankruptcies 117

3.1 Introduction 118

3.2 Partnerships 118

3.3 S Corporations 140

Chapter Four

Taxation of Bankruptcy Estates and Debtors 151

4.1 Introduction 152

4.2 Responsibility for Filing Income Tax Returns 152

4.3 Accounting for the Bankruptcy Estate 156

4.4 Accounting for the Debtor (Individual) 203

4.5 Summary 214

Chapter Five

Corporate Reorganizations 217

5.1 Introduction 218

5.2 Elements Common to Many Reorganization Provisions 219

5.3 Overview of Specific Tax-Free Reorganizations Under Section 368 232

5.4 Acquisitive Reorganizations 232

Contents

n viii n

5.5 Stock Acquisitions 243

5.6 Single Entity Reorganizations 252

5.7 Divisive Reorganizations 257

5.8 Insolvency Reorganizations 268

5.9 Summary 281

Chapter Six

Use of Net Operating Losses 283

6.1 Introduction 284

6.2 I.R.C. Section 381 286

6.3 Restructuring Under Prior I.R.C. Section 382 291

6.4 Current I.R.C. Section 382 293

6.5 I.R.C. Section 383: Carryovers other than Net Operating Losses 346

6.6 I.R.C. Section 384 347

6.7 I.R.C. Section 269: Transactions to Evade or Avoid Tax 351

6.8 Libson Shops Doctrine 357

6.9 Consolidated Return Regulations 358

Chapter Seven

Other Corporate Issues 369

7.1 Introduction 370

7.2 Earnings and Profits 370

7.3 Incorporation 374

7.4 Liquidation 377

7.5 I.R.C. Section 338 381

7.6 Other Tax Considerations 394

7.7 Administrative Expenses 397

7.8 Other Administrative Issues 405

Chapter Eight

State and Local Taxes 409

8.1 Introduction 409

8.2 Income from Debt Discharge 410

8.3 Net Operating Loss Carryback and Carryover 413

8.4 Bankruptcy Estate 416

8.5 Responsibility for Filing Tax Returns 419

8.6 Stamp Tax 420

8.7 Summary 424

Chapter Nine

Tax Consequences to Creditors of Loss

from Debt Forgiveness 425

9.1 Introduction 426

9.2 Nature of Losses 426

9.3 Business and Nonbusiness Losses 428

9.4 Determination of Worthlessness 436

9.5 Secured Debt 445

Contents

n ix n

9.6 Reorganization 452

Chapter Ten

Tax Procedures and Litigation 455

10.1 Introduction 455

10.2 Notice and Filing Requirements 456

10.3 Tax Determination 457

10.4 Bankruptcy Courts 515

10.5 Minimization of Tax and Related Payments 518

10.6 Appendix: Forms 520

Chapter Eleven

Tax Priorities and Discharge 535

11.1 Introduction 536

11.2 Priorities 536

11.3 Tax Discharge 608

Chapter Twelve

Tax Preferences and Liens 639

12.1 Introduction 639

12.2 Tax Preferences 639

12.3 Tax Liens 646

Appendix A Internal Revenue Code: Selected Sections 673

Appendix B Senate Report No. 96-1035 on H.R. 5043—Bankruptcy Tax

Act of 1980 721

Appendix C Senate Proposed Amendments to H.R. 5043 (Bankruptcy

Tax Act of 1980) Adopted by Both Senate and House 757

Appendix D Representative Ullman’s Statement Regarding Bankruptcy

Tax Legislation 767

Appendix E Selected Provisions from the General Explanation

of the Tax Reform Act of 1986 (H.R. 3838, 99th Congress;

Public Law 99-514) 781

Appendix F Selected Provisions from the Explanation of the Technical

and Miscellaneous Revenue Act of 1988 829

Appendix G Tax Consequences of Plan—Revco 845

Statutes Citations 851

Treasury Regulations, Revenue Procedures, and Revenue Rulings Citations 857

Case Index 861

Subject Index 870

n xi n

Preface

This book is designed to provide a broad range of guidance on the tax aspects of

decisions that must be made by companies in financial trouble. It will be useful

to financial advisors, accountants, lawyers, trustees, turnaround professionals,

examiners, creditors, bankruptcy judges, and debtors-in-possession.

The tax provisions of the Internal Revenue Code (I.R.C.) and the Bankruptcy

Code applicable to businesses that have filed a chapter 7 or a chapter 11 bank￾ruptcy petition are discussed in detail. Also explained are the provisions of the

debtor and its creditors. Special attention is given to the I.R.C. sections contained

in the Tax Reform Act of 1980 and revisions of these sections by subsequent leg￾islation, including the Tax Reform Act of 1984 and 1986, the Revenue Act of 1987,

the Technical and Miscellaneous Revenue Act of 1988, the Revenue Reconcilia￾tion Act of 1990, the Omnibus Budget Reconciliation Act of 1993, Taxpayer Relief

Act of 1977, the Job Creation and Worker Assistance Act of 2002, and other public

laws related to taxes as well as other areas involving tax law changes.

The first edition of Bankruptcy and Insolvency Taxation was a revision of the

authors’ Tax Planning for the Troubled Business, first published in 1983 and

revised annually. This edition, revising the second edition, will be updated

annually or more frequently if needed because of tax law changes. Bankruptcy

and Insolvency Taxation is one of four books by the author and published by John

Wiley & Sons dealing with bankruptcy and insolvency taxation and accounting.

The others are Bankruptcy and Insolvency Accounting: Practice and Procedure, Bank￾ruptcy and Insolvency Accounting: Forms and Exhibits, and Corporate Bankruptcy.

Chapter 1 describes the general provisions of the Bankruptcy Code applica￾ble to debtors who have filed a chapter 7 or chapter 11 petition. Chapter 2 con￾tains a discussion of how the debtor accounts for the tax impact of debt

discharge, including the exchange of stock for debt. Included is a description of

regulations issued dealing with basis adjustment and debt modifications. Chap￾ter 3 deals with the tax impact of an out-of-court workout or bankruptcy pro￾ceeding in a partnership or an S corporation, including a discussion of the

Supreme Court decision in Gitlitz and subsequent legislation changes overturn￾ing Gitlitz. Chapter 4 examines the basic procedures that apply to the tax returns

that must be filed by individuals, partners, and corporations in a chapter 7 or a

chapter 11 case. The carryover of tax attributes, including regulations issued

dealing with gain on sale of residence, to the estate of an individual debtor cre￾ated when the bankruptcy petition is filed, and the subsequent succession of the

tax attributes by the debtor once the case has been completed are also explained.

Chapter 5 examines tax-free reorganizations under I.R.C. section 368, with

special emphasis on type “G” reorganization, established by the Bankruptcy Tax

Act of 1980. The use of net operating loss carryovers and other tax attributes by

companies that go through a complete internal reorganization, or that are reor￾ganized by the use of another corporation, is the subject of Chapter 6. Both

Preface

n xii n

Chapters 5 and 6 contain a detailed discussion of the many regulations and rules

issued to implement the relevant provisions of the Internal Revenue Code.

Chapter 7 discusses several corporate tax topics not covered in previous

chapters, including: liquidations, the use of I.R.C. section 338, incorporation

under I.R.C. section 351, and the determination of whether an issue is debt or

stock.

Chapter 8 deals with the state and local tax impact of income from debt dis￾charge and related areas that are important for state and local tax purposes.

Chapter 9 covers the tax impact that reorganization and income from debt

discharge may have on the creditors.

Tax procedures are described in Chapter 10, tax priorities and discharge are

examined in Chapter 11, and Chapter 12 contains a discussion of tax preferences

and liens.

Chapters 2 through 7 and 9 through 12 have been updated to reflect cases

that have been decided and pronouncements that have been issued by the IRS

since the Second Edition was published.

Included in the Appendixes are relevant sections of the Internal Revenue

Code and related sections of legislative history.

This author acknowledges the many contributions made by coauthor Gilbert

D. Bloom, Esq., in the Washington National Tax Practice of KPMG, LPP, over a

period of almost 20 years beginning with the first volume published in 1983, and

welcomes Robert L. Liquerman, also with the National Tax Practice of KPMG,

LLP, as coauthor.

Comments from users are welcomed.

Grant W. Newton

Malibu, California

March 2005

Mr. Liquerman appreciates the assistance provided by Christine W. Booth and

Mary Van Leuven, also in the Washington National Tax Practice of KPMG, LLP,

in preparing this edition. He also thanks his many other colleagues at KPMG,

LLP, for their insights and contributions in preparing this book.

Robert Liquerman

n 1 n

CHAPTER ONE 1

Nature of Bankruptcy &

Insolvency Proceedings

§ 1.1 Objectives 1

(a) Introduction 1

(b) Scope of Coverage 2

§ 1.2 Alternatives Available to a

Financially Troubled Business 3

(a) Out-of-Court Settlements 3

(i) Creditors’ Committee, 3

(A) Duties of Committee, 4

(ii) Plan of Settlement, 4

(iii) Acceptance of Plan, 5

(iv) Advantages and

Disadvantages, 5

(b) Assignment for Benefit of

Creditors 6

(c) Bankruptcy Court Proceedings 6

(d) Provisions Common to All

Bankruptcy Proceedings 7

(i) Automatic Stay, 7

(ii) Priorities, 8

(iii) Discharge of Debts, 8

(iv) Preferences, 8

(e) Chapter 7: Liquidation 9

(i) Appointment of

Trustee, 10

(f) Chapter 11: Reorganization 11

(i) Creditors’ Committee, 11

(ii) Operation of Business, 11

(iii) Disclosure Statement, 12

(iv) Developing the Plan, 12

(v) Confirmation of the

Plan, 13

(vi) Discharge of Debts, 15

(vii) Advantages of

Chapter 11, 15

(viii) Prepackaged or

Prenegotiated Chapter 11

Plans, 15

(g) Chapter 12: Adjustment of

Debts of a Family Farmer with

Regular Annual Income 16

(h) Chapter 13: Adjustment of

Debts of an Individual with

Regular Income 17

(i) Operation of Business, 18

(ii) Chapter 13 Plan, 18

(i) U.S. Trustee 19

§ 1.1 OBJECTIVES

(a) Introduction

The income tax effect of certain transactions during the administration period

and of tax assessments related to pre-bankruptcy periods can impose undue

hardship on the bankrupt, who is already in a tenuous financial position. It is

not uncommon for a bankrupt to realize substantial taxable income during the

administration period from the sale of all or part of the assets or from taxable

recoveries. Net operating loss carryovers and other offsetting tax deductions are

often unable to minimize the income tax effect. Therefore, in addition to