Document Number
03-72
Tax Type
Individual Income Tax
Description
Chapter 11 Bankruptcy
Topic
Collection of Delinquent Tax
Constitutional Provisions
Partnerships
Date Issued
10-15-2003
October 15, 2003


Re: § 58.1-1821 Application: Individual Income Tax

Dear *****:

This will reply to your letter in which you seek correction of the Virginia individual income tax assessments issued to ***** (the "Taxpayers") for the taxable years ended December 31, 1993 and 1995. I sincerely apologize for the unusual delay in responding to your letter.
FACTS

The Taxpayers are husband and wife. The husband was a partner in a partnership that filed Chapter 11 Bankruptcy and liquidated the business. The trustee of the partnership requested a closing agreement from the Internal Revenue Service in connection with the partnership liquidation.

One of the issues addressed in the closing agreement was the cancellation of indebtedness that was included as income on the federal partnership return and distributed to the partners. According to the terms of the closing agreement, the cancellation of indebtedness realized by the partnership was to be allocated to each partner. The cancellation of indebtedness allocated to a partner was to be recognized over a ten-year period at stipulated percentage rates, and the balance to be recognized in the eleventh year.

The Taxpayers included their distributive share of cancellation of indebtedness on their federal returns for the taxable years 1993 and 1995. On their Virginia individual income tax returns, the Taxpayers claimed subtractions for the cancellation of indebtedness income. The Department disallowed the subtractions and issued assessments. The Taxpayers paid the 1993 assessment and request a refund along with the abatement of the 1995 assessment.

You contend that the allocation of cancellation of indebtedness is not subject to Virginia income tax pursuant to special tax provisions of the Federal Bankruptcy Act, Title 11 U.S.C. §§ 346(a) and (j).
DETERMINATION

There have been several attempts to modernize the bankruptcy laws. Congress enacted the Bankruptcy Reform Act of 1978 (the "1978 Act"), P.L. 95-598 (1978), codified at 11 U.S.C. § 101, et seq. According to the House of Representatives' report, "[F]rom a historical perspective, Congress has taken great care to insure that tax policy will not frustrate the operation of bankruptcy." (See H.R. Rep. No. 595, 95th Cong., 1st Sess. 334 (1977), reprinted in 1978 U.S. C.C. A.N. 6231, 6232.) In discussing the legislative history of special tax provisions for bankruptcy, this report further indicated that:
    • [T]here is a strong bankruptcy policy that these provisions apply equally to Federal, State, and local taxes. However, in order to avoid any possible jurisdictional conflict with the Ways and Means Committee over the applicability of these provisions to Federal taxes, H.R. 8200 has been amended to make the sections inapplicable to Federal taxes . . . . Though the bill has been amended to remove Federal taxes from the scope of the four sections, the discussion in this section will proceed as though the bill has not been so amended. This will give a better picture of how these provisions would apply to Federal taxes should the Ways and Means Committee decide in its bankruptcy-tax bill to follow with respect to Federal taxes the proposals made here with respect to State and local taxes. (Emphasis added.)

The clear intention of Congress is to treat federal, state, and local taxes equally. To treat state and local taxes differently from the federal tax laws after they were excluded from the 1978 Act would be inconsistent with the clear congressional intent of the bankruptcy laws. After amendment, the state and local tax aspects remained in the 1978 Act pursuant to 11 U.S.C. § 346(a), which provides:
    • Except to the extent otherwise provided in this section, subsections (b), (c), (d), (e), (g), (h), (i), and (j) of this section apply not withstanding any State or local law imposing a tax, but subject to the Internal Revenue Code of 1986.

Although the wording of the statute may seem unclear, the fact that this provision pertains to state and location taxation is confirmed in Eric T. Page v. Internal Revenue Service, 73 A.F.T.R.2d 94-1095 (1994), which provides that:
    • [T]he statute states plainly enough that the listed subsections . . . do not apply to the IRC but only to state and local laws. To the extent any doubt remains, both the legislative history and a leading bankruptcy treatise support this reading and indicate Congress left Federal tax provisions for later considerations. (Emphasis added.)

11 U.S.C.A. § 3460)(1), addresses special tax provisions for the treatment cancellation of indebtedness for state and local tax purposes. In pertinent part, this statute states:
    • Except as otherwise provided in this subsection, income is not realized by the estate, the debtor, or a successor to the debtor by reason of forgiveness or discharge of indebtedness in a case under this title [11 U.S.C.A. §§ 101 et seq.].

This statute is followed by several paragraphs on the treatment of recognition of income, reduction of basis, and reduction of loss carryovers. Although it pertains to state and local taxes, as has been previously stated, the congressional intent was that the federal, state, and local tax treatment be equal. As a result, the treatment of cancellation of indebtedness for state tax purposes should not be different from the treatment for federal purposes even though the federal tax aspects were removed from the Bankruptcy Reform Act.

The Bankruptcy Tax Act of 1980 (the "1980 Act"), P.L. 96-589, 94 Stat. (1980) incorporated the federal tax aspects removed from the 1978 Act and was codified in the Internal Revenue Code ("IRC"). In part, it provided for the treatment of cancellation of indebtedness. IRC § 108(d)(6) provides that income from cancellation of indebtedness is not excludible at the partnership level. Instead, the cancellation of indebtedness is passed to the partners of the partnership. The solvency of the partners determines whether the cancellation of indebtedness may be included or excluded from income. If the partner is solvent, his distributive share of the cancellation of indebtedness must be reported in gross income. If the partner is in bankruptcy, the bankruptcy estate will typically not be required to recognize the income. If the partner is insolvent but not in bankruptcy, the cancellation of indebtedness is not recognized as income unless the partner is made solvent immediately after the discharge of the debt. In that the Taxpayers were solvent partners of the partnership, the cancellation of indebtedness was properly included as income on their federal income tax return.

Virginia Code § 58.1-301 provides that the terms used in Virginia law as it relates to individual income taxation shall have the same meaning as terms used in the IRC. Accordingly, Virginia law provides that the starting point for computing Virginia taxable income is federal adjusted gross income with certain additions, subtractions, exemptions, and deduction modifications as specified in Va. Code § 58.1-322. As Virginia conforms with federal tax law, a cancellation of indebtedness is subject to Virginia taxation to the extent it is included in federal adjusted gross income. Additionally, there is no provision in Va. Code § 58.1-322 for a subtraction of cancellation of indebtedness that is included in income. As a result, the Department properly disallowed the cancellation of indebtedness claimed as a subtraction on your 1993 and 1995 Virginia individual income tax returns and issued the appropriate assessments.

Based on the information provided, there is no basis to adjust your individual income tax assessments for the taxable years 1993 and 1995. A refund for 1993 cannot be granted. Additionally, the 1995 assessment is correct and the balance (see enclosed schedule) should be paid within thirty days from the date of this letter to avoid the accrual of additional interest.

Copies of the Code of Virginia sections cited and other reference documents are available on-line in the Tax Policy Library section of the Department of Taxation's website, located at www.tax.state.va.us. If you have any questions regarding this response, you may contact ***** in the Department's Office of Policy and Administration, Policy Development, at *****.
                • Sincerely,

                • Kenneth W. Thorson
                  Tax Commissioner


Enclosure

PD/11819N

Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46