ESTATES AND TRUSTS

May 2001

A Bankruptcy Trustee Can Avoid a Taxpayer’s ‘Irrevocable’ Election to Carry Forward Unused Net Operating Losses

By Bruce M. Bird, J. Harrison McCraw, and Michael Raper

Certain provisions of the Internal Revenue Code (IRC) and the Bankruptcy Code (BC) do not always mesh seamlessly. Take, for example, a taxpayer’s irrevocable election under IRC section 172(b)(3) to carry forward a net operating loss (NOL) to offset tax liability in future years: If the taxpayer files for bankruptcy, the bankruptcy trustee may argue that the section 172(b)(3) election, while irrevocable for tax purposes, is nonetheless avoidable by the bankruptcy trustee under the fraudulent transfer provision of BC section 548.

The U.S. Court of Appeals for the Ninth Circuit examined this issue in detail in its recent decision In re: Feiler [also cited as U.S. v. Sims; 218 F.3d 948, 2000-2 U.S.T.C. (CCH) para. 50,579 (9th Cir. 2000)].

Feiler

In October 1994, James and Carol Feiler filed a properly extended married filing jointly tax return for the 1993 tax year. This return reflected a net operating loss (NOL) of approximately $972,000. Under the law in effect for treating the NOL for tax purposes, taxpayers had the option of either doing nothing or making an irrevocable election. If the taxpayer did nothing, the NOL would first be carried back and applied to each of the three taxable years preceding the year of loss. The remaining NOL, if any, would then be carried forward and applied against each of the next 15 taxable years following the year of the loss. The taxpayer could instead affirmatively and irrevocably elect to waive the NOL carryback and instead carry it forward to be applied against future tax liability.

The Feilers made an irrevocable election under section 172(b)(3) to carry forward the NOL. At the time of this election, the Feilers were insolvent. Five months later, the Feilers filed a voluntary petition under BC Chapter 7.

In 1997, the Chapter 7 trustee, acting on behalf of the Feilers’ bankruptcy estate, filed income tax return refund requests with the IRS for tax years 1990 and 1991. The total refund request was $287,493, reflecting the tax refund that the Feilers would have been entitled to had they done nothing instead of electing to carry forward the NOL. The IRS disallowed the refund claims for both years. Soon thereafter, the trustee filed an adversary proceeding against the IRS seeking to avoid the Feilers’ irrevocable election under IRC section 172(b)(3) as a fraudulent transfer under BC section 548. Under this provision, a bankruptcy trustee may, under certain circumstances, avoid any transfer of an interest of the debtor in property, or any obligation incurred by the debtor, that was made or incurred on or within one year before the date of filing the petition.

In 1998, the Bankruptcy Court granted summary judgment in favor of the bankruptcy trustee. The IRS appealed to the Ninth Circuit Bankruptcy Appellate Panel (BAP), which affirmed the decision. The IRS then appealed to the U.S. Court of Appeals for the Ninth Circuit.

The IRS’s Position

In disallowing the trustee’s refund requests, the IRS relied upon the language of IRC sections 172(b)(3) and 1398. IRC section 172(b)(3) provides that the election to waive the NOL carryback “once made for any taxable year shall be irrevocable for such taxable year.” In addition, IRC section 1398 provides that the bankruptcy estate shall succeed to and take into account the debtor’s NOL determined under section 172 as of the first day of the debtor’s taxable year in which the bankruptcy action commences. Section 1398 is sometimes referred to as the provision by which the bankruptcy trustee “steps into the shoes” of the debtor with respect to certain tax attributes.

The IRS argued that the language of IRC sections 172(b)(3) and 1398, when taken together, demonstrated clear congressional intent to place the section 172(b)(3) election beyond the bankruptcy trustee’s power to avoid under the fraudulent conveyance rules of BC section 548.

The Court of Appeals Decision

In its de novo review of the Bankruptcy Court’s rulings, the Court of Appeals for the Ninth Circuit examined issues of law and statutory interpretation. The facts in Feiler were undisputed.

In interpreting IRC section 172(b)(3), the appellate court agreed with the IRS that the election to waive the carryback is irrevocable by a debtor/taxpayer for such tax year. However, the court then noted that the bankruptcy trustee is not constrained to act only as the debtor could. Although the trustee succeeds to the tax attributes of the debtor, he does not represent the debtor’s interests. Rather, the trustee has the duty to maximize the recoverable assets of the bankruptcy estate on behalf of the creditors. As a result, the court noted that the mere fact the IRC section 172(b)(3) election is irrevocable by a debtor is not helpful in determining whether it may be avoided by a trustee under BC section 548.

The court then examined the IRS’s contention that IRC sections 172(b)(3) and 1398, taken together, preclude the bankruptcy trustee from exercising avoidance powers. Under IRC section 1398, the NOL carryovers had already been determined as of the first day of the taxable year in which the bankruptcy case commenced (because the Feilers had already waived the carryback in the previous year). However, what a bankruptcy trustee “succeeds to” under IRC section 1398 is not the same as what can be avoided under BC section 548. What property is part of the bankruptcy estate and what property may be recovered with a trustee’s avoidance powers are two separate questions.

Generally, under BC section 541(a)(1), a trustee “succeeds to” a debtor’s interest in property but retains the right to use BC section 548 powers to avoid the obligations of transactions succeeded to from the debtor in order to recover property from the estate. The avoided transaction is nullified and treated as if it never happened. Accordingly, whether the debtor’s election to carry forward the NOL is a fraudulent transfer depends upon whether the transfer satisfies the provisions of BC section 548.

BC Section 548

Under BC section 548, a bankruptcy trustee may, under certain circumstances, avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor on or within one year before filing the petition. The fraudulent transfer rules can apply in one of two situations:

  • A debtor, either voluntarily or involuntarily, makes a transfer or incurs an obligation with the actual intent to hinder, delay, or defraud any entity to which the debtor is (or later becomes) indebted.
  • A debtor transfers an interest in property while insolvent and receives less than a reasonably equivalent value in exchange.

    In either situation, the transfer of an interest or incurring of an obligation by the debtor must occur within one year of the bankruptcy filing. Although the first situation requires the trustee to prove the debtor’s intent to hinder, delay, or defraud, the second situation does not.

    In Feiler, the bankruptcy trustee contended that BC section 548(a)(1)(B) applied because the Feilers transferred an interest in property while insolvent and received less than reasonably equivalent value. The IRS contended that the Feilers’ election to forgo a tax refund was not a “transfer of an interest of the debtor in property.”

    In analyzing the IRS’s contentions, the court first noted that the term “property” is broadly defined by the Bankruptcy Code. Under BC section 541, property includes “all legal or equitable interests of the debtor.” Furthermore, as the Supreme Court explained in Segal v. Rochelle [382 U.S. 375 (1966)], interest in property can include one that is novel, contingent, or whose enjoyment must be postponed.

    In Segal, a decision under the old Bankruptcy Act, the debtors incurred NOLs that gave the right to a tax refund when carried back and applied to past tax years. Later in that same tax year, the debtors filed for bankruptcy. The Supreme Court held that the resulting NOL carryback claim constituted an “interest in property” at the time of the bankruptcy petitions, even though the petitions were filed in the middle of the taxable year and the taxpayers did not yet have a right to the tax refunds. The court in Feiler noted that Segal, although decided under the old Bankruptcy Act, remains good law. In enacting the current Bankruptcy Code, Congress affirmatively and specifically adopted the Supreme Court’s holding in Segal.

    The Feiler court next examined whether the NOLs themselves are considered an interest in property. Under BC section 548, the issue is whether the Feilers gave up property of the bankruptcy estate. The property given up was the tax refund itself. Pre-election, the right to carry back the NOL represented simply the right to a tax refund. After the election, whether the Feilers retained a property interest in the NOL carried forward is irrelevant, because the bankruptcy trustee, in order to avoid a fraudulent transfer, need not have a property interest in what a debtor receives in return. Stated alternatively, because the Feilers’ pre-election right to a refund was an interest in property, the election to relinquish that right to a refund involved an “interest of the debtor in property” within the scope of the bankruptcy trustee’s avoidance powers.

    The Feiler court then examined whether a transfer had occurred. The court held that it had indeed occurred because the Feilers traded the right to a refund to the IRS in exchange for the right to carry the NOLs forward and apply them against income on future tax returns.

    Tax Implications

    Under prior law, NOLs were typically carried back three years and carried forward 15. Under current law, an NOL can be carried back two years and carried forward 20. The carryback period remains three years under current law both for NOL of individuals attributable to casualty and theft losses and for NOL incurred by farmers or small businesses in declared disaster areas [IRC section 172(b)(1)(F)].

    Under both prior and current law [IRC section 172(b)(3)], a taxpayer may make an irrevocable election for tax purposes to relinquish the entire carryback period with respect to an NOL for any taxable year. As a result, although Feiler was decided under prior law, it remains good law for the purposes of determining whether a bankruptcy trustee can avoid a taxpayer’s irrevocable election waiving the NOL carryback period for tax purposes.

    A taxpayer’s irrevocable election to forgo the NOL carryback period for purposes of the regular federal income tax also applies for purposes of the alternative minimum tax (AMT) [IRC section 56(a)(4)]. NOLs for regular federal income tax purposes must be recomputed for AMT purposes in the form of the alternative tax net operating loss deduction (ATNOLD), which may not offset more that 90% of a taxpayer’s alternative minimum taxable income (AMTI) computed without regard to the ATNOLD itself. Basically, the ATNOLD is designed to prohibit tax preference items or adjustments that make up a taxpayer’s NOL for regular income tax purposes from reducing the taxpayer’s AMTI.

    In a given year, a taxpayer can have an ATNOLD for AMT purposes but not an NOL for regular federal income tax purposes. If the taxpayer desires to forgo the ATNOLD carryback period for a given year, the taxpayer is still required to make an irrevocable election to forgo the NOL carryback for regular tax purposes. From the holding of the Feiler decision, if the fraudulent transfer rules of the Bankruptcy Code apply, it would appear that a bankruptcy trustee could avoid the taxpayer’s irrevocable election.

    Another possibility is for a taxpayer to make an invalid irrevocable election to forgo the carryback period. This occurred in Plumb [97 TC 632 (1991)], in which the taxpayer’s return contained the statement “Taxpayer elects to forgo the carryback period for the regular NOL in accordance with section 172(b)(3)(C) and will carry forward this NOL to subsequent years.” The Tax Court held that the taxpayer’s refund claim, based on an ATNOLD carryback from the year in question, was improper. The taxpayer had made an invalid election because he did not forgo the carryback periods for both regular tax and AMT purposes. Accordingly, the Tax Court required the taxpayer to apply the carryback and carryforward rules for both the regular tax NOL and AMT purposes. In such a situation, it is simply unnecessary for a bankruptcy trustee to do anything to avoid a taxpayer’s irrevocable election that is, on its face, invalid.


    Bruce M. Bird is a professor in the department of accounting and finance, J. Harrison McCraw, an associate professor in the department of accounting and finance, and Michael Raper, an associate professor in the department of economics, all at the Richards College of Business, University of West Georgia, Carrollton.

    Editors:
    Lawrence M. Lipoff, CPA
    Deloitte & Touche LLP

    Susan R. Schoenfeld, JD, LLM, CPA
    Bessemer Trust Company, N.A.

    Contributing Editors:
    Jerome Landau, CPA

    Debra M. Simon, MST, CPA
    The Videre Group, LLP

    Richard H. Sonet, JD, CPA
    Marks Paneth & Shron LLP

    Peter Brizard, CPA

    Ellen G. Gordon, CPA
    Margolin Winer & Evens LLP

    Jeffrey S. Gold, CPA

    Joseph R. Beyda & Company P.C.

    Harriet B. Salupsky, CPA
    Weinick Sanders Leventhal & Company LLP


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