A Review of Farm Bankruptcy
The founders of our country believed that debtors should have an opportunity for a fresh start. The Constitution authorizes Congress to create bankruptcy laws. U.S. Const. Art. I, Sect. 8. The U.S. Supreme Court has stated, “Bankruptcy gives to the honest but unfortunate debtor…a new opportunity in life and a clear field for future effort, unhampered by the pressure and discouragement of preexisting debt.” Local Loan Co. v. Hunt, 292 U.S. 234, 244 (1934). This fresh start occurs through a “bankruptcy discharge,” which generally releases debtors from personal liability for certain debts, preventing creditors from collecting those debts in the future.
The current Bankruptcy Code (enacted in 1978) created six different types of bankruptcy cases. These bankruptcy provisions are usually referenced by the number of the Chapter in the Code where they are found.
- Chapter 7 – Liquidation
- Chapter 9 - Municipalities
- Chapter 11 – Business Reorganization
- Chapter 12 – Family Farmer Reorganization
- Chapter 13 – Individuals with Regular Income
- Chapter 15 – Cross-Border Insolvency
In 2019, Congress passed the Small Business Reorganization Act, which provides a new option for small businesses wishing to reorganize. This new provision, Subchapter V of Chapter 11, is available only to small business debtors with no more than $2,725,625 in debt. The CARES Act temporarily expanded this limit to $7,500,000.
Although Chapter 12 is specifically designed for the family farmer, farmers may file for bankruptcy relief under Chapters 7, 11, 12, or 13. Each provision has advantages and limitations.
Initiating a Case
A voluntary bankruptcy case is commenced by filing a petition with the bankruptcy court. The filing of the petition constitutes an “order of relief.” 11 U.S.C. § 301.
Although the provisions of the different chapters are very different, they all share the protection of an “automatic stay.” At the time a bankruptcy petition is filed, the automatic stay temporarily halts lawsuits, foreclosures, garnishments, and creditor collection activities. The length and application of the stay vary according to the type of bankruptcy. Because of the automatic stay, the bankruptcy court generally oversees tax claims, tax determinations, and tax discharges in bankruptcy.
Chapter 7 is a liquidation bankruptcy. This means that the farmer is getting out of business. The debtor initiates this relief by filing a petition, including a schedule of assets and liabilities, a schedule of income and expenses, a statement of financial affairs, and a schedule of contracts and unexpired leases. This filing creates an “estate” comprising all of the debtor’s property. In a Chapter 7 action, the court appoints a trustee to collect the debtor’s non-exempt assets, reduce some to cash, and make distributions to creditors as provided in the Code. Secured creditors generally retain the benefit of their security interests in particular collateral. An unsecured creditor, upon making a proof of claim, receives payment under Chapter 7 only if proceeds from assets not pledged to secured creditors are available to sell. Then, unsecured creditors generally collect on a pro-rata basis in relation to the amount of their claims, as compared to the overall debt. But first, the trustee must pay the cost of administration and priority unsecured claims, such as child support and tax debt.
Individuals, partnerships, and corporations (with some exceptions) can file for Chapter 7 bankruptcy protection, but only individuals can receive a discharge, releasing them from personal liability for certain dischargeable debts. Some debts, such as child support, are not dischargeable in bankruptcy. Likewise, only individual debtors are allowed to keep assets considered “exempt” under either the Bankruptcy Code and state law. 11 U.S.C. § 522. The Bankruptcy Code allows states to replace federal exemptions with their own. In some jurisdictions, the individual debtor may choose between the federal exemptions or the state law exemptions. Some of the federal bankruptcy exemptions include:
- Automobile ($4,000 in equity in one vehicle)
- Child Support and Alimony
- Health Aids
- Implements, books, and tools of the trade up to $2,525.
- Jewelry (up to $1,700)
- Personal Injury Settlement up to $25,150
- Animals, crops, clothing, appliances and furnishings, books, household goods, and musical instruments (up to $625 per item or $13,400 total)
- Pensions and IRAs up to $1,362,800
- Homestead ($25,150 in equity)
The States of Illinois and Iowa (see, e.g., Iowa Code § 627.6; Iowa Code §§ 499A.18, 561.2, 561.16) provide their own state exemptions. Wisconsin applies the federal exemptions.
Corporations or partnerships liquidating under Chapter 7 must distribute all of their assets to creditors. Corporations are terminated after a Chapter 7 liquidation. General partners remain personally liable for the unpaid debt of a partnership after a liquidation.
The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 prohibits debtors from discharging debt under Chapter 7 if they have the “means” or income to make payments over a period of time to creditors. These debtors must instead file for Chapter 13 relief. Chapter 13 is generally designed for the discharge of consumer debt, not business debt.
In a Chapter 7 bankruptcy, the secured creditor is generally entitled to retrieve non-exempt collateral, unless the debtor chooses to redeem or reaffirm the debt. Debtors typically have 30 days from the filing of the petition to make this declaration. Secured creditors are not entitled to the value of the collateral in excess of the debt owed.
The primary advantages of a Chapter 7 liquidation bankruptcy are that it is relatively inexpensive, and it generally requires only 90 days from filing to discharge.
Chapter 11 of the Bankruptcy Code allows business debtors to reorganize their debt and continue operating their business. It is not well designed for a farming business because of its “absolute priority” rule (described below), its administrative complexity, and its expense. It is, however, the only bankruptcy reorganization option for a farming business with debt exceeding $10 million.
A Chapter 11 petition may be filed by individuals, partnerships, and corporations, with certain exceptions. Along with the petition, the debtor must file schedules of assets and liabilities, a schedule of current income and expenditures, a schedule of executory contracts and unexpired leases, and a statement of financial affairs. Chapter 11 has no debt limit.
In a Chapter 11 case, the “debtor in possession” acts as a fiduciary, responsible for accounting for property, examining and objecting to claims, and filing information reports. A United States trustee supervises the administration of the case. The trustee, for example, conducts a meeting of the creditors. A creditors’ committee ensures fair representation to the unsecured creditors. The debtor has 120 days after the filing of the petition to file a reorganization plan, and 180 to have the plan “accepted” by the creditors. The court can extend these deadlines if necessary. Creditors have the right to reject a plan. To be confirmed, at least one class of impaired creditors must accept the plan.
Any party in interest may file an objection to confirming the plan. The court will hold a confirmation hearing, after which the court must find that the plan is:
- The court must find that confirmation is not likely to be followed by liquidation or the need for another reorganization.
- Proposed in good faith
- In the best interest of creditors
- Providing adequate protection payments to secured creditors if the stay, use, sale, or lease of assets under the bankruptcy will result in a decrease in the value of the collateral
- Providing that claims and interests are designated in classes (i.e., secured, unsecured with priority, unsecured, etc.)
- Providing that any classes of claims or interests that are impaired or unimpaired under the plan are specified
- Providing that the debtor may not receive or retain any property under the plan unless claims of the impaired dissenting classes of unsecured creditors are paid in full (or the debtor contributes new value). An impaired class of creditors accepts a plan only if it is approved by two-thirds in amount and a majority in number of the holders of claims who cast votes.
- In other words, the plan must provide for the payment of all debt unless the creditors agree otherwise. (absolute priority)
- Otherwise in compliance with the Bankruptcy Code
The Court has a “mandatory independent duty” to determine whether the plan conforms to these requirements. The confirmation of the plan discharges the debtor from debts that arose before the date of the confirmation. Once the plan is confirmed, the debtor must make payments and is contractually bound by the plan of reorganization. Confirmation vests the property of the estate in the debtor. The automatic stay is lifted, and any default after confirmation means that creditors can use state law remedies to collect. Once the estate has been fully administered, a final decree closing the estate is entered.
Chapter 11 can provide longer payment schedules, including 15 to 30 years for real estate and three to seven years for machinery. Interest rates are generally two percent greater than the yield on U.S. Treasury notes or bonds. After filing, the debtor must seek approval of the court to obtain additional secured debt. Similarly, the use of cash collateral is not allowed absent approval of creditors or the court. The court requires monthly reports, and the trustee fees are paid by the debtor. Chapter 11 provides no specific time period for making repayments under the confirmed plan. The feasibility requirement, however, limits the length to one that is reasonable. For many smaller business debtors, the period is three to five years.
Originally enacted in 1986 to provide temporary relief for “family farmers,” Congress made Chapter 12 permanent in 2005. Chapter 12 was created during the farm crisis of the 1980s because Chapter 11 was unworkable for these debtors. Most significantly, the absolute priority rule of Chapter 11 prevented farm debtors from retaining any equity interest in their farm over the objection of unsecured creditors, unless those creditors were paid in full. It was also administratively burdensome and costly. In most cases, financially distressed farmers had no choice but to liquidate. Since the inception of the Chapter 12 bankruptcy, Congress has provided debtors with favorable tax treatment to allow them to downsize and remain in business. This special tax provision is discussed more thoroughly below.
Eligibility - Individuals
A Chapter 12 case may be filed by a “family farmer or family fisherman with regular annual income.” [i] 11 U.S.C. § 109(f). To qualify as a “family farmer” eligible for Chapter 12 bankruptcy, the following requirements must be met:
- Must be engaged in farming operations at the time of filing.
- Does not generally include former farmers or those who are engaged in farm-related businesses or lease-only activities, but off-farm income can be used to make payments. In re Williams, No. 15-11023, 2016 Bankr. LEXIS 1804 (W.D. Ky.).
- Farmer's debts cannot exceed $10,000,000 (adjusted every three years).
- The original debt limit was $1,500,000, which was raised to $3,237,000 in 2005. By 2019, inflation had increased the limit to $4,411,400, but this amount kept some otherwise “family farmers” from qualifying for Chapter 12 protection. On August 23, 2019, the Family Farmer Relief Act of 2019 went into effect. This law increased the amount of debt a “family farmer” may have to $10,000,000.
- Fifty percent of this index-adjusted debt must arise from the farming operation.
- The home mortgage is included only if it secures the farm debt.
- Must have earned more than half of gross income from farming in year prior (or in each of the 2nd and 3rd years prior to the filing).
- Gross income, evidenced on line 9 of Schedule F should be used (not gross receipts). Tax return is prima facie evidence.
11 U.S.C. § 101(18).
Eligibility - Entities
Corporations or partnerships, including LLCs, are eligible for file for Chapter 12 bankruptcy protection if:
- More than 50 percent of the outstanding stock or equity is held by one family, or by one family and the relatives of the members of such family (relative is interpreted broadly);
- The family or such relatives must conduct the farming operation;
- At least 80 percent of the value of its assets consists of assets related to the farming operation;
- The total indebtedness cannot exceed $10,000,000 (less for a commercial fishing operation);
- At least 50 percent of its aggregate non-contingent, liquidated debts on the date the case is filed, arise out of the farming operation owned or operated by such corporation or such partnership; and
- Residential debt exclusion can count if a shareholder or partner lives in the house, even if they are not involved in the farming operation.
- No stock is publicly traded
Chapter 12 Commencement
To initiate a Chapter 12, the debtor files a petition including a schedule of assets and liabilities, a schedule of current income and expenses, a schedule of executory contracts and unexpired leases, and a statement of financial affairs. Husbands and wives may file joint or individual petitions. Upon filing, the automatic stay begins, and a trustee is appointed to oversee the case. The clerk provides notice of the proceeding to all creditors listed in the paperwork filed by the debtor.
The Proposed Plan
The debtor must file a plan within 90 days of the bankruptcy petition (unless the court extends the deadline). The plan payment period is generally three years unless the court approves a longer plan “for cause.” 11 U.S.C. § 1222(c). The longer period is required if the plan does not propose to pay 100 percent of child support or alimony claims. In that case, the five-year plan must propose to spend all of the debtor’s disposable income.
Chapter 12 offers a number of favorable tax and non-tax related provisions to debtors. The most helpful non-tax provision of Chapter 12 is the abrogation of the absolute priority rule. Instead of requiring debtors to repay all debt, Chapter 12 requires that unsecured creditors must receive as much as they would in a Chapter 7 liquidation. Additional non-tax requirements of a Chapter 12 plan include:
- Net disposable income must be paid to the trustee for distribution to unsecured creditors until discharge. 11 U.S.C. § 1222(a)(1).
- The plan must provide for full payment, in deferred cash payments, of all priority claims under 11 U.S.C. § 507, unless the holder of the claim agrees to accept less favorable treatment, 11 U.S.C. § 1222(a)(2).
- The plan must provide the same treatment for each class of claim or interest within a particular class unless the holder of claim or class agrees to less favorable treatment, 11 U.S.C. § 1222(a)(3).
In addition to these requirements, the Chapter 12 plan may include these provisions:
- The plan may treat claims for a consumer debt of the debtor where the debtor is a co-obligor differently than other unsecured claims, 11 U.S.C. § 1222(b)(1).
- The plan may modify the rights of holders of secured claims, including the rights of residential mortgage lenders, 11 U.S.C. § 1222(b)(2);
- Contracts for repayment of secured debt can be extended or re-amortized (15 to 30 years for real estate or three to seven years for machinery). Interest paid on secured claims is typically two percent above the yield on a U.S. Treasury note or bond. Till v. SCS Credit Corp., 541 U.S. 465 (2004).
- The plan may provide for the curing or waiving of any default, 11 U.S.C. § 1222(b)(3);
- The plan may provide for payments on any unsecured claim to be made concurrently with payments on any secured claim or other unsecured claim, 11 U.S.C. § 1222(b)(4);
- The plan may permit the debtor to assume, reject or assign any executory contract of unexpired lease of the debtor to the extent permitted by 11 U.S.C. § 365 and to the extent not previously rejected by the debtor, 11 U.S.C. § 1222(b)(6);
- The plan may provide for payment from either property of the estate or other property of the debtor, 11 U.S.C. § 1222(b)(7);
- The plan may provide for the sale of all or any part of the property of the estate or the distribution of all or any part of the property of the estate among those having an interest in the property, 11 U.S.C. § 1222(b)(8); and
- The plan may provide for the payment of allowed secured claims for a discretionary period–including beyond the period of the plan for making payments to the trustee, as determined by the debtor, 11 U.S.C. § 1222(b)(9).
Operation of the Farm During Pendency of the Case
The debtor will continue to operate the farm as provided in 11 U.S.C. § 1203. As a fiduciary of the bankruptcy estate, the debtor must pay all taxes owed to the IRS and state taxing authorities. The debtor may also engage in the following activities:
- Dispose of property in the estate in the ordinary course of business without notice and a hearing.
- This means that the debtor can use proceeds from sales of grain, livestock, and milk not pledged to a secured creditor for living expenses and for continued farming activities.
- The debtor may obtain unsecured credit in the ordinary course of business, and the debt will be allowable as an administrative expense under 11 U.S.C. § 503(b)(1).
- The Chapter 12 trustee may sell machinery or farmland or farm equipment free and clear of any interest of an entity other than the estate under circumstances other than those permitted by 11 U.S.C. § 363(f), the latter of which is available to the debtor.
- This provision is unique to chapter 12 cases and allows for the right sizing of farming operations prior to the proposal of a chapter 12 plan.
The debtor, however, must receive court approval for the following:
- Using, selling or leasing property in the non-ordinary course of business. This includes the sale or purchase of machinery or livestock or real property. 11 U.S.C. § 363(c).
- Using cash collateral. If the cash collateral is used, adequate protection must be provided.
- To acquire secured or priority debt. 11 U.S.C. §1206.
Within 45 days of the debtor filing the plan, the court will hold a confirmation hearing to ensure that the requirements of the Code are met. To be confirmed, the debtor bears the burden to show that the plan must meet the following requirements set forth in 11 U.S.C. § 1225:
- The plan was proposed in good faith.
- All fees and costs are paid.
- The plan meets the “best interest of the creditors test,” meaning that the property to be distributed to pay unsecured claims is equal to or greater than the amount that would be paid on each claim in a Chapter 7 case.
- The plan must provide for the secured creditor in one of three ways: (1) through a consensual agreement with the debtor, (2) by surrendering the collateral to the creditor, or (3) by allowing the secured creditor to retain the lien and receive the present value of the secured portion of its claim.
- Adequate protection must be provided to secured creditors to protect the value of their interest in the collateral retained by the debtor. 11 U.S.C. § 1205(b)(1)–(3).
- The plan must be “feasible,” meaning that the debtor will be able to make all required payments.
- The debtor must be current on post-petition domestic support obligations.
- If an unsecured claim holder or the trustee objects, the plan will be confirmed if:
- The plan devotes all disposable income to making payments under the plan,
- The value of the property to be distributed under the plan is not less than the debtor’s disposable income, or
- The property to be distributed under the plan on account of an unsecured claim has a value, as of the effective date of the plan, not less than the amount of the claim.
With rare exception, confirmation of the Chapter 12 plan vests all property of the estate in the debtor. 11 U.S.C. § 1227(b). This property will be free and clear of any claim or interest of any creditor provided for in the plan. 11 U.S.C. § 1227(c).
Once the plan is confirmed, the trustee distributes funds to creditors according to the terms of the plan. The debtor must provide the trustee with a monthly report. The Chapter 12 debtor receives a discharge only after all of the plan payments are made. Debt such as alimony or child support is not dischargeable. Rarely, the debtor may receive a “hardship” discharge for extraordinary circumstances, even if all payments are not made. A standard discharge under 11 U.S.C. § 1228(a) covers all debts of the debtor provided for by the plan, with the exception of secured debts to be paid beyond the plan term and any debts specifically excepted from discharge under 11 U.S.C. § 523(a).
Taxation in Bankruptcy
A separate taxable bankruptcy estate is created when an individual seeks Chapter 7 or Chapter 11 bankruptcy protection. In these cases, the trustee files a Form 1041 on behalf of the estate. At the conclusion of the proceedings, the debtor takes over any remaining tax attributes, including those that first arose during the administration of the bankruptcy estate.
No separate taxable bankruptcy estate is created in Chapter 12 or when a corporation or partnership seeks bankruptcy protection. In a Chapter 12 bankruptcy, the debtor continues to file the same federal income tax returns that were filed prior to the bankruptcy petition, Form 1040 or 1040-SR, U.S. Individual Income Tax Return. The debtors report all income received during the entire year and deduct all allowable expenses. Debt canceled due to the debtor's bankruptcy is not included in income. I.R.C. § 108(A)(1)(a). To the extent the debtor has any losses, credits, or basis in property that were previously reduced as a result of canceled debt, these reductions must be included on the debtor's return.
Tax liens are secured claims. Federal tax liens arise at the time the tax is assessed and attach to all the taxpayer's property, as well as the taxpayer's after-acquired property. The lien continues until the tax and related penalties and interest are paid. Because the IRS may enforce its lien even if the tax debt is discharged, bankruptcy should be filed before the IRS files its lien.
In a bankruptcy, federal tax claims secured by a federal tax lien that are valid against the bankruptcy trustee are usually satisfied first. After that, unsecured federal tax claims generally must compete with other unsecured claims. Whether they are paid will depend upon their assigned priority. 11 U.S.C. § 507. Outside of Chapter 12, most tax claims are priority unsecured claims. Unsecured claims without a priority status are satisfied last. A special rule impacts tax claims secured with perfected tax liens in a Chapter 7 case. 11 U.S.C. 724(b). These claims are satisfied after unsecured priority seven claims (including administrative expenses and domestic support claims) and just before unsecured priority eight claims (priority unsecured tax claims).
Creditors (including the IRS) must file a proof of claim with the bankruptcy court. A claim for taxes can be either a claim secured by a perfected tax lien or an unsecured claim. Perfected liens generally pass through bankruptcy proceedings unaffected, even if the debtor's personal liability for the debt is discharged.
Chapter 11 plans will not be confirmed if the IRS or state taxing authority holding an unsecured priority tax claim objects to the plan unless the plan provides that the holder will receive regular installment payments in cash:
- In an amount equal to the allowed amount of the claim;
- over a period no longer than five years from the date of the petition; and
- in a manner no less favorable than the most favored nonpriority unsecured claim
If the IRS makes a special request, the court will not confirm a reorganization plan if the principal purpose of the reorganization plan was the avoidance of taxes. 11 U.S.C. 1129(d). This provision does not apply to Chapter 12.
Special Chapter 12 Tax Rule
A key change implemented by the BAPCPA was the addition of 11 U.S.C. § 1222(a)(2)(A). This provision retained the requirement that a Chapter 12 must provide for full payment of § 507 priority unsecured claims, but stated that claims owed to a governmental unit that arose as a result of the “sale, transfer, exchange, or other disposition of a farm asset used in the debtor’s farming operation” were treated as general unsecured claims subject to discharge.
Stripping these claims of their priority was intended to allow Chapter 12 confirmations that otherwise would be denied because of large capital gain or depreciation recapture arising from the sale of farm assets. Before this rule, if a farmer sold assets in an effort to raise cash to allow the farming operation to continue, the tax bill generated by the sale subsumed a good part of the proceeds and robbed the debtor of the cash needed to make payments under a plan. The plan would fail because it would not be feasible.
Although helpful, 11 U.S.C. § 1222(a)(2)(A) led to a split in the circuits regarding whether the rule applied to prepetition and post-petition sales. Ultimately, the United States Supreme Court sided with the Ninth Circuit and ruled that the special rule applied only to prepetition sales. Hall v. U.S., 132 S. Ct. 1882 (2012). The 5-4 decision made it nearly impossible for farmers to discharge in a Chapter 12 bankruptcy capital gains tax or depreciation recapture income arising due to the sale of property after the filing of the petition. This prevented debtors from right-sizing once the bankruptcy petition was filed.
On October 26, 2017, The Family Farmer Bankruptcy Clarification Act of 2017 fixed this problem by creating new 11 U.S.C. § 1232. The provision states:
- Any unsecured claim of a governmental unit against the debtor or the estate that arises before the filing of the petition, or that arises after the filing of the petition and before the debtor’s discharge under section 1228, as a result of the sale, transfer, exchange, or other disposition of any property used in the debtor’s farming operation—
- shall be treated as an unsecured claim arising before the date on which the petition is filed;
- shall not be entitled to priority under section 507;
- shall be provided for under a plan; and
- shall be discharged in accordance with section 1228.
In other words, if a debtor sells property after the Chapter 12 has been filed, the special priority-stripping rule applies to the gain in the same way as if the assets were sold before the filing. By treating tax claims as general unsecured claims, farmers can retain more property necessary to continue their farming operation rather than being forced to sell it to pay off tax liability.
Which Claims Qualify?
There remains some debate among courts as to what claims (beyond those arising from capital gain from the sale of a farming asset) are impacted by the priority-stripping provisions of § 1222 (now § 1232). Courts often apply a five-factor test in making this determination: The claim arose (1) as a result of (2) the sale, transfer, exchange, or other disposition (3) of any property (4) used in (5) the debtor’s farming operation. Courts have found this to include income from the sale of crops and livestock, Knudson v IRS, 581 F.3d 696 (8th Cir. 2009), a partnership interest in a farming operation, Hemann, 2013 WL 1385404 (Bankr. N.D. Iowa 2013), and crop insurance proceeds, In re Pedersen, 593 B.R. 785 (Bankr. N.D. Iowa 2018). In a pre-2017 case, a Kansas court found that the provision did not apply to crop insurance proceeds. In re Keith, case No. 10-12997, 2013 WL 3467315 (Bankr. D. Kan. Jul.8, 2013).
In determining the amount of the claim that is stripped of its priority, the Eighth Circuit has allowed what’s been called the “marginal method” of calculation. No court has rejected this method. Under the marginal method, the tax professional prepares a traditional and a pro forma return. The traditional return is the actual return for the year at issue. It is the only return that will be filed. The pro forma return is calculated without the income from the sale of the farm property.
The difference between the tax due on these two returns is the amount that is deprioritized under § 1232. This amount is reported to the court in the proposed plan.
Considerations Before Filing Chapter 12
Chapter 12 provides the following key advantages:
- Deprioritization of tax claims, allowing farm property to be sold to restructure the business in a more efficient way.
- Debtor may retain the asset, even though the unsecured creditors do not receive full payment for their claims, as long as all disposable income is paid out during the plan period. There is no absolute priority rule.
- The debtor may reduce the balance of secured claims to the value of the collateral, including the claim against the debtor’s house.
- The automatic stay applies to co-debtors on consumer debts as well.
- Payment terms on secured debt can be stretched out, re-amortized, and the interest rate adjusted.
- Payments may be made on a monthly, yearly, or other basis, depending upon the income stream of the farm.
- The process is efficient and economical.
Limitations of Chapter 12
For most debtors, the most challenging Chapter 12 requirement is feasibility. Debtors who have been unable to continue their operation because of financial impairment may be hard pressed to show that they will be able to make the required plan payments. In recent history less than 50 percent of Chapter 12 plans have been successfully completed through discharge. That could change given recent changes to the Code detailed above.
In the 1980s, Chapter 12 was able to restructure debt payments with much lower interest rates. Today’s low interest rates generally remove this benefit; however, debtors may be able to generate cash if they sell assets to right-size the farm. This is made possible by the special Chapter 12 tax provisions.
When determining whether to file a Chapter 12 bankruptcy, a debtor must consider:
- Feasibility as determined through cash flow projections,
- The liquidation value of the assets, to show that the unsecured creditors would receive as much under the plan as in liquidation, and
- The timing of the filing with respect to the sale of assets, tax attributes such as NOLs, and other considerations.
Discharge of Debt Income
Sometimes outside of bankruptcy lenders will forgive some or all of a financially distressed taxpayer’s debt. Generally, if a creditor forgives debt for any reason other than for making a gift to the debtor, the income is included in the taxpayer’s income as cancellation of debt income (CODI). The same rule applies to repossessed property. The taxpayer will be deemed to have sold the repossessed property at its fair market value to the lender. The difference between the FMV and the debt owed is CODI, potentially subject to income tax. In the case of depreciated equipment, the taxpayer will also owe ordinary income tax for the I.R.C. § 1245 recapture in the year of repossession.
A number of exceptions, however, apply to this rule. I.R.C. § 108(a)(1) provides that gross income generally does not include CODI if any of the following apply:
- The cancellation takes place in a bankruptcy case
- The cancellation takes place when the debtor is insolvent
- The canceled debt is a “qualified farm debt”
- The canceled debt is a qualified real property business debt (in the case of a tax-payer other than a C corporation)
- The canceled debt is qualified principal residence indebtedness which is discharged before 2018
Qualified Farm Indebtedness
Farmers can exclude CODI from gross income if it is qualified farm debt owed to a qualified person. This exclusion applies only if the farmer was solvent when the debt was canceled or, if insolvent, it applies only to the extent the canceled debt is more than the amount by which the debtor was insolvent. Debt is qualified farm debt if both the following requirements are met: (1) It was incurred directly in operating a farming business and (2) at least 50 percent of gross receipts for the last three years preceding the year of debt cancellation were from the farming business.
A qualified person is a person actively and regularly engaged in the business of lending money. A qualified person includes any federal, state, or local government, or any of their agencies or subdivisions. The USDA is a qualified person. A qualified person does not include a related person, a person who receives a fee from the taxpayer’s investment in the property, or a person from whom the taxpayer acquired the property.
Reducing Tax Attributes
Generally, if a taxpayer is able to exclude canceled debt from income under one of the exclusions noted above, they must reduce the following tax attributes (certain credits and carryovers, losses and carryovers, basis of assets, etc.) (but not below zero) by the amount of the canceled debt excluded.
- NOLs and NOL carryovers for year of discharge
- Net capital loss and capital loss carryovers for year of discharge
- Passive activity loss carryovers from year of discharge
- Three times the sum of the following:
- General business credit carryover
- Minimum tax credit available as of the following tax year
- Foreign tax credit carryover to or from the year of discharge and
- Passive activity credit carryover from year of discharge
[i] Although this provision also protects family fisherman, this article only discusses farmers.
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