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Companies experiencing financial distress sometimes use a Chapter 11 bankruptcy case to liquidate substantially all their assets. The liquidation may be through asset sales that are approved by the bankruptcy court through a motion to sell under Section 363 of the Bankruptcy Code. A debtor may also seek confirmation of a liquidating plan. The liquidating plan may provide for the sale of the debtor’s assets to a third party. The liquidating plan may also provide for the transfer of substantially all of the debtor’s assets to a Liquidating Trust. (For more insight, see our recent blog post - 2 approaches to the sale of assets in liquidating Chapter 11 cases.)

In any of these liquidation scenarios, the bankruptcy estate may realize substantial capital gains income after considering the debtor's adjusted basis in the property. Income may be generated for the bankruptcy estate because the debtor’s property was either sold or there was a taxable transfer to a third party. However, the debtor's other taxable events in the year and available net operating loss carryovers from prior years are considered in calculating the tax.

At the time a bankruptcy petition is filed, all of the debtor’s assets become property of a “bankruptcy estate.” The transfer of assets by the debtor to the bankruptcy estate is not treated as a taxable disposition. After the bankruptcy case has been initiated, income generated from assets included in a bankruptcy estate is included in the bankruptcy estate's income. Thus, if the bankruptcy estate disposes of assets and triggers income tax liability in the process, the income tax liability is a priority claim in the estate as an administrative expense. As a result, the tax due is paid after allowed secured claims are paid in full and ahead of claims of general unsecured creditors.

Upon the creation of the bankruptcy estate, the trustee or debtor in possession becomes liable to pay any federal and state income tax due on the bankruptcy estate's taxable income (see, e.g., Holywell Corporation v. Smith, 503 U.S. 47, 52 (1992) (citing Sec. 6151(a) of the Internal Revenue Code, which provides, in relevant part, "[W]hen a return of tax is required . . . the person required to make such return shall . . . pay such tax.").

Disadvantages of an asset sale

One disadvantage of an asset sale, as opposed to a transfer of assets under a confirmed plan of reorganization, is the lack of any exemption from stamp taxes or similar taxes under Section 1146 of the Bankruptcy Code. Florida Dept. of Revenue v. Piccadilly Cafeterias, Inc., 554 U.S. 33, 128 S. Ct. 2326, 171 L.Ed.2d 203 (2008) (Section 1146 of the Bankruptcy Code is inapplicable to asset sales outside of a confirmed plan). The Supreme Court overruled cases holding that the exemption set forth in Section 1146 of the Bankruptcy Code could apply absent any plan of reorganization.

Tax attribute carryovers from tax years ending before the commencement of bankruptcy can be used only by the bankruptcy estate while it is in existence (Sec. 1398(g); Benton v. Commissioner of Internal Revenue, 122 T.C. 353 (2004); Linsenmeyer, No. 03-1172 (6th Cir. 2003). Therefore, the debtor's tax attribute carryovers from prior tax periods become available to offset the federal income tax liability of the bankruptcy estate during the bankruptcy case.

Takeaways for bankruptcy professionals

In considering asset sale transactions in liquidating Chapter 11 bankruptcy cases outside of a plan of reorganization, bankruptcy professionals need to determine whether or not there are capital gains, and whether or not there are enough net operating losses or other tax attributes to offset taxable income generated by the bankruptcy estate, such that there is no federal or state income tax liability owed by the bankruptcy estate.  
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