How to Eliminate Trustee Tax Liability Resulting from the Administration of a Chapter 7 Case
by Fred Dery
Fred J. Dery & Associates PC; Troy, Mich.
Trustees were previously required to wait seven years after filing a tax return before distributing money to creditors. Seven years is the statutory period the Internal Revenue Service (IRS) has to audit an income tax return after it is filed. If the IRS did not audit the return during the seven-year period, the return was considered accepted as filed and the IRS could not assess any additional tax against the trustee or the estate. It became apparent to the IRS that distributions to creditors were being slowed down because of this seven-year requirement. The IRS was experiencing a delay in payments they were to receive from an estate and they were hampered in pursuing collection activities against individuals who might be individually liable for estate tax liabilities (i.e., trust fund taxes). To speed up the payment of creditor distributions by the bankruptcy, the IRS formulated Revenue Procedure 76-23 titled “Regarding Prompt Determinations.” This was in place for several years until the enactment of the new bankruptcy law on Oct. 17, 2005. To update the revenue procedure regarding prompt determinations, the IRS enacted Revenue Procedure 2006-24. The purpose and intent of this procedure is to accelerate the payments to creditors and to assist the trustee in closing out their cases on a timely basis.
A trustee is required by the IRS, pursuant to IRS Publication 908, “Bankruptcy Tax Guide,” to file all applicable tax returns. This publication states, “[t]he trustee is generally responsible for preparing and filing the estate’s tax returns and paying its taxes.” Further, relating to corporations, IRS Publication 908 provides that “[t]he filing of required returns becomes the responsibility of an appointed trustee, receiver or debtor-in-possession rather than a corporate officer.”
In addition to IRS Publication 908, the trustee’s handbook for chapter 7 trustees states that “[t]he trustee must file a federal income tax return in an individual chapter 7 case for any year in which gross income of the estate equals or exceeds the exemption amount under 26 U.S.C. §151(a) plus the basic standard deduction under 26 U.S.C. §63(c)(2)(d): for a taxpayer filing as married but filing separately for 2005 tax returns, the exemption amount is $3,200 and the standard deduction is $5,000 for a total of $8,200.” The handbook further provides that “[i]f a husband and wife file a joint petition under [Bankruptcy Code] §302, absent substantive consolidation, two separate estates and two separate entities are created. Each estate obtains its own tax identification number and files its own tax returns.” For non-exempt corporations, corporate tax returns must be filed by the trustee regardless of whether the corporation has income.
As the trustee administers the case, he has three options relating to taxes:
- Do not file a tax return and hope the taxing authority does not assert a tax liability against the trustee or the estate - This option ignores the trustee handbook and the requirements of the IRS. Additionally, if no tax return is filed, not only is the trustee not fulfilling his fiduciary duty, there is no statute of limitations that begins to run, and the taxing authority has the option of asserting a liability any time in the future. Further, it is the position of the IRS that if a trustee does not properly perform the fiduciary duties they are required to, the trustee may become personally liable for the income tax liability of the estate. In addition to incurring the tax liability, there are late-filing penalties that can be as high as 34.5 percent in addition to interest.
- File a tax return and pay any tax due – This complies with the requirements of the IRS and the handbook. In addition, the filing of the return starts a statue of limitations running, and the taxing authority has seven years from the date of filing the tax return to assert a tax liability.
- File a 60-day prompt determination request under §505(b)(2) of the Bankruptcy Code – On May 30, 2006, the IRS issued Revenue Procedure 2006-24, which states that during the administration of a bankruptcy estate, the trustee is required to file tax returns for the estate and pay the tax shown thereon. The submitting of a tax return for the estate’s tax, paying the tax on the return and requesting a prompt determination starts a 60-day statute of limitations running. The IRS has 60 days to accept the return as filed or notify the trustee that it intends to audit the return. Once the 60-day period expires, if the IRS has not notified the trustee that it intends to audit the return, then the return is accepted as filed and the IRS is forever barred from asserting any tax liability against the trustee or against the estate. If the IRS audits the return, it has 180 days to complete the audit. Once the audit is resolved, the Internal Revenue Service is forever barred from asserting an additional claim for taxes.
In addition to the length of the statute of limitations, the option the trustee selects to address tax liability directly impacts his record retainage requirement. If the trustee decides to file no tax return, he should retain the financial records of the debtor for an unlimited period of time. If the trustee decides to file a tax return without requesting a prompt determination, he should retain the financial records of the debtor for seven years. However, if the trustee decides to file a prompt determination request, he should retain the financial records of the debtor for 60 days (the length of the statute of limitations). This fulfills the requirements of the IRS and the handbook, and eliminates any further tax liability to the trustee and to the estate. Finally, because the administration of the bankruptcy estate is not complete until all potential tax claims against the trustee and estate have been eliminated, requesting a prompt determination will greatly decrease the amount of time needed to finalize administration of the estate.
In summary, the trustee is responsible for filing the tax returns. By requesting a prompt determination, the trustee decreases the statute of limitations for the IRS, decreases his record-retention time and also decreases the time needed to complete the administration of the estate. Also, by following this procedure the trustee eliminates any personal liability for the income tax liability of the estate.