Net Operating Losses And Bankruptcy

As a bankruptcy lawyer  I often encounter people who need to file bankruptcy, because of losses incurred in the operation of a business.  Since the Internal Revenue Code allows taxpayers, whose business expenses exceed their business income, to carry unused losses backwards and forwards as deductions in other tax years, one might wonder if it is possible to discharge one’s debts in bankruptcy and then take advantage of the tax deductions for the losses that drove one to bankruptcy to reduce future tax liability .

The short answer is that this is not very likely to happen.

As a general rule the cancellation of debt creates taxable income.   Debt discharged in a bankruptcy is an exception to this rule, however, the taxpayer is required to reduce any unused net operating loss by the amount of cancelled debt that escaped taxation in bankruptcy.  And if the cancelled debt exceeds the net operating deduction the taxpayer might then have to reduce other tax attributes, such as capital loss carryovers, business tax credit carryovers, and their tax basis of property.

Of course it is possible that the net operating loss deduction could exceed the amount of debt cancelled in bankruptcy, and then some of the carryover deduction would still be available for later years.  This could happen for example if the taxpayer invested a large amount of capital in the business rather than having relied mostly on debt financing for the enterprise.