Who pays capital gain taxes relating to the sale of appreciated property sold to pay creditors in a Chapter 13 bankruptcy?

Often debtors facing financial crisis have the ability to pay all or a large portion of their debts.  Yet, the cash available to pay these debts is tied up in illiquid investments (i.e. raw land, rental properties, etc.).  These debtors often utilized a Chapter 13 bankruptcy as a means of obtaining immediate relief from aggressive creditors while attempting to liquidate assets to satisfy their debts. These debtors need to beware of the potential capital gain tax consequences associated with selling appreciated assets.

At of the time a bankruptcy petition is filed, all of the debtor’s assets become property of a “bankruptcy estate”.  See 11 U.S.C. § 541.  In a Chapter 13 case, the bankruptcy estate includes all of the debtor’s earnings from the date the bankruptcy is filed through the date the case is closed.  11 U.S.C. § 1306(a)(2).  To confirm a Chapter 13 plan of reorganization, the debtor must pay all “projected disposable income” into the Chapter 13 plan.  So, when an appreciated asset is sold to pay creditor and all of the debtor’s income is being paid to creditors; who pays the capital gain taxes?  From most people, the knee-jerk reactionary response would be: it only makes sense that the Chapter 13 Trustee should pay the taxes from the money paid through the Chapter 13 plan.  Unfortunately, in some cases, this may not be the correct answer.

In an unpublished but very detailed memorandum decision entered by Judge Joel B. Rosenthal, Bankruptcy Court Judge for the District of Massachusetts, In re Brown, 2006 WL 3370867 (2006), it was held that the tax liability can be satisfied from the amount paid into the Chapter 13 plan only if the taxing authority filed a post-petition proof of claim pursuant to 11 U.S.C. § 1305(a)(1).  Such a proof of claim enables the debtor to treat the claim as if it had been incurred prior to the date the bankruptcy was filed as opposed to being treated like every other post-petition debt.  The Brown court clarified that

The choice belongs to the creditor, however, as the effect of filing the proof of claim is to treat the postpetition claim as arising prepetition. If the creditor does not file a postpetition claim, a debtor may not file one for him. [citation omitted].  Instead the creditor may chose to await discharge and then pursue its claim against the debtor directly. [citation omitted]. The postpetition tax creditor does not have a choice between filing a proof of claim under § 1305 or receiving an administrative claim under § 503(b)(10(B). The result is no different if it is a debtor attempting to force the taxing authority into accepting treatment under the plan, even if the treatment is payment in full.

Brown, 2006 WL 3370867 at Pg. 2.

While the Brown decision is an unpublished memorandum decision, Bankruptcy Courts from the District of Arizona have seen the well-reasoned decision as authoritative.  See In re Hall, 376 B.R. 741, 745-47 (Bkrtcy.D.Ariz.,2007).  Accordingly, debtors seeking to liquidate appreciated assets to satisfy debt in a Chapter 13 bankruptcy need to be aware that if the IRS does not cooperate and file an appropriate post-petition proof of claim, the debtor may be responsible for the capital gain tax liability associated with the sale but lack the ability to pay the taxes from the sale proceeds or any income earned during the pendency of their Chapter 13 bankruptcy.

For more information, or to register for one of our free bankruptcy seminars, please visit www.mcguiregardner.com or www.freearizonabankruptcyseminar.com.