Corporate Bankruptcy: Treatment of Filing Year Income Tax - A Suggested Approach

The focus of this article is the proper treatment in a chapter 7 or 11 bankruptcy proceeding of the federal income tax incurred by a corporate debtor for the year in which the bankruptcy petition is filed, the so-called "straddle-year." Normally, for federal income tax purposes, the obligation to pay tax arises at the end of the taxable period, whether that is a calendar or fiscal year. Under Internal Revenue Code sections 1398 and 1399 when an individual files a bankruptcy petition under chapters 7 or 11 of the Bankruptcy Code, the bankruptcy estate created is a separate taxable entity from the debtor and the debtor has an election available to terminate his/her taxable year as of the day before the petition is filed. When a corporation is involved in a bankruptcy proceeding, the estate is not a separate entity and no election to terminate the debtor's taxable year is available. Accordingly, under the IRC, when a bankruptcy petition is filed by a corporate taxpayer in middle of the tax year, the tax for that year would be determined in the usual manner, without regard to the bankruptcy petition. Bankruptcy law places great emphasis on when a tax is incurred and gives different priority to taxes incurred pre and post-petition. Generally, every tax incurred by the bankruptcy estate, i.e., post-petition, is an administrative expense entitled to first priority status. Bankruptcy Code, 11 U.S.C. section 503. Other income taxes of the debtor, including pre-petition federal income tax, generally are entitled to eighth priority status under Bankruptcy Code section 507(a)(8). In determining how to treat the straddle year income tax, no court seems inclined to simply treat the tax under the normal income tax rules - as if it arose at the end of the taxable year - since this would give the income tax for the entire straddle year administrative expense status. Instead, every court that has addressed this issue has determined it is necessary to bifurcate the straddle year tax into pre and post-petition portions and to extend first priority administrative expense status only to the post-petition portion, while the pre-petition portion receives eighth priority status. While some of the courts have addressed the fact that such treatment is, or, at least, may appear to be inconsistent with the federal income tax rules, no court has actually focused on how the division between pre and post-petition portions of the year is, or should be, accomplished. It is the author's contention that if it is necessary to divide the straddle year taxes into pre and post-petition portions, it must be done in accordance with the IRC's normal apportioning mechanism, and that is to apportion based solely on the amount of time in each period. Such apportionment would satisfy bankruptcy policy without violating the relevant tax provisions. What empathetically may not be done is to apportion based on the net income earned pre-petition and the net income earned post-petition. Unfortunately, not only do the courts not focus on this issue, it is not even possible to surmise how the apportionment was done in the reported cases.