Partnership Bankruptcy Tax Issues

1. INTRODUCTION

   Bankruptcies and restructurings involving partners and partnerships1 raise a number of unique tax issues. While the Internal Revenue Service (the "IRS") has provided guidance with respect to a number of these issues, a surprising number of unresolved issues remain. The first part of this outline summarizes the state of the law with respect to general tax issues that typically arise in connection with partner and partnership bankruptcies and restructurings. The balance of the outline discusses tax issues that arise under Subchapter K when troubled partnerships are reorganized.

2. GENERAL ISSUES

   1. Individual Partner Debtors and Their Estates

   1. Creation of New Entity

      For purposes of Federal, state or local income taxes, the filing of a bankruptcy petition for or against an individual partner creates a separate taxable entity.2 The partner and the bankruptcy estate must file separate tax returns.

      The bankruptcy estate succeeds to the debtor's post-bankruptcy interest in the debtor's assets, including income, gain, loss and deductions of partnerships owned by the debtor.3 For Federal income tax purposes, the bankruptcy estate succeeds to most of the debtor's tax attributes existing at the time of the bankruptcy filing.4 No new taxable entity is created for Federal income tax purposes where the debtor is a partnership or a corporation.5 State and local tax provisions of the bankruptcy code conform to Federal income tax treatment for these purposes.6 "No Disposition Rule" The transfer of the debtor's assets to the individual's bankruptcy estate is not a taxable event.7 Thus, no gain or loss is recognized; no investment credit or depreciation is recaptured; and no installment gain is accelerated.8 Since the transfer of a partnership interest to a partner's bankruptcy estate is not a disposition, a bankruptcy filing by a partner does not trigger a partnership termination under section 708(b)(1)(B), does not close the partnership books with respect to the partner under section 706(c), and does not cause a change in interest under section 706(d).9 Treasury Regulations further provide that no sale or exchange occurs upon a disposition by gift (including assignment to a successor in interest).10 Presumably, the bankruptcy estate is a "successor in interest." Query whether the transfer of partnership liabilities to the bankruptcy estate creates a constructive distribution of money that triggers gain for the bankrupt partner if and to the extent the amount deemed distributed exceeds the partner's basis in his partnership interest.11 This result would be contrary to the policy of section 1398(f)(1). 2. Taxable Years of an Individual Partner and the Bankruptcy Estate

      Bankruptcy Filing Does Not Close Individual's Taxable Year For the year of the bankruptcy filing, an individual partner reports all his income earned during the year, but does not include any income earned by the bankruptcy estate. Unless the individual elects to divide his taxable year (as described below), the corresponding tax is a liability of the partner rather than a claim against the partner's bankruptcy estate.12 The treatment is different in the case of income and loss flowing from a partnership to a partner that files for bankruptcy. The Tax Court has interpreted section...