Bankruptcy can hold hidden tax hazards

Tax relief legislation hasn't fared well this year. President Clinton vetoed both the legislation that would have abolished the inheritance "death tax" and a measure that would have eliminated the so-called "marriage penalty." Congress couldn't muster enough votes to override either veto.

Still pending, as Congress' working days rapidly dwindle, is legislation to reform bankruptcy laws. While the president supports such reform, he is less than happy with proposals advanced thus far. And because of a number of attempts to attach unrelated riders, it's anybody's guess as to whether anything will be enacted before the lawmaking process shuts down this year.

With yet another season of in-the-cellar prices, weather-shortened crops, escalating input costs, and higher borrowing costs, some farmers may not be able to stay afloat financially, facing the possibility of being forced out of business.

And that, says Sikeston, Mo., certified public accountant Philip M. Showmaker, can hold the risk of "catastrophic tax traps" unless the debtor does some astute planning.

In many cases, he notes, the debtor may work out a deal with the lending institution to give back the property that is collateral for the loan. "This is normally the worst step to take" from an income tax standpoint, because the fair market value of the property given back is treated as though the property was sold.

"This can create a huge tax liability if the property has a very low basis for income tax purposes," Showmaker says.

An example: Farmer Jones bought his land 20 years ago for $100,000. Now it's worth $250,000. But because of refinancing and a drop in land values, there is a note of $300,000 attached to the property. If the land is voluntarily given back to the bank, Jones will have a tax gain of $150,000 (fair market value of $250,000 less the tax basis of $100,000). The remainder of the loan, $50,000, if forgiven by the lender, could then become income to Jones.

"Thus, the taxpayer has given back his land, has no money or assets, and still faces a $150,000 taxable gain to report on his income tax return," Showmaker says. He ends up with no money, but a big tax liability. (This example is for an unincorporated farmer; bankruptcy for corporations and partnerships is handled differently. Each situation must be reviewed on an individual basis.)

This can be avoided through proper planning. If Farmer Jones instead files bankruptcy and lets the bankruptcy court sell the property, it will keep the tax in the bankrupt entity and not at the individual level.

"In many cases," Showmaker points out, "the bankruptcy court will take property that has no value (more is owed against it than it is worth) and then abandon it back to the bankrupt individual - which is a terrible step. This will move the income tax burden back to the individual."

If the bankruptcy court keeps the property and sells it, or just gives it to the creditor, Farmer Jones has no tax, Showmaker says. "The IRS can then only collect on the assets remaining in the bankrupt estate. If there are no assets, there will be no tax."

For any farmer considering bankruptcy, he says, "It is imperative that his attorney understand the pitfalls that can arise out of bankruptcy. Tax can't always be avoided, but proper planning can help to minimize the tax liability.

"It's a terrible situation to see an individual work all his life and then lose everything due to financial misfortunes," Showmaker says. "But to add to that the problem of a large tax liability makes the situation even worse - especially when it can be avoided through planning."

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