Deductibility of Bankruptcy Costs and the Origin of the Claim

Recent bankruptcy legislation has made it more expensive to discharge debts in bankruptcy, making any deductions a debtor can take related to a bankruptcy filing more important than ever.

August 2009
by Debra Sanders, et al./The Tax Adviser

Between 1995 and 2005, the number of personal bankruptcies filed annually in the United States grew from approximately 900,000 to over two million. In 2005, in an effort to stem abuses of personal bankruptcy laws, the Bankruptcy Abuse Prevention and Consumer Protection Act (BAPCPA) was enacted, which increased bankruptcy filing costs and made debt discharge, including income taxes owed, more difficult. Therefore, maximizing bankruptcy filers' tax deductions has become more important in facilitating the fresh start filers seek.

One category of income tax deductions that practitioners and taxpayers may overlook is the costs of the actual bankruptcy filing. Normally, costs of personal bankruptcy are not deductible on an individual's tax return. However, in circumstances in which the proximate cause of the personal bankruptcy is a prior business failure, the origin-of-the-claim doctrine supports the deduction of the portion of personal bankruptcy costs that relate to the business failure.

A factor complicating the application of the origin-of-the-claim doctrine is that the relationship between business failure and personal bankruptcy may not be immediately apparent, especially in cases where the business failure occurred in a year prior to that of the bankruptcy filing. The taxpayer's employment status (e.g., the taxpayer is employed by others at the time of filing) may also mask the underlying business cause of the bankruptcy. In addition, many small business owners use personal credit as a means of obtaining business funds, frequently commingling personal and business debts, which may also obscure the business origins of personal debts.

Overall, it is critical that a tax practitioner ascertain the origin of a personal bankruptcy filer's debts in order to provide appropriate tax advice and maximize allowable deductions, particularly in light of the current economic turbulence.

This article has been excerpted from The Tax Adviser. View the full article here (PDF).