Avoiding Phantom Income in Bankruptcy: A Proposal for Reform

Abstract

Chapter 11 of the Bankruptcy Code' was designed to give the debtor a breathing spell from creditors by granting the debtor time to formulate a reorganization plan without having to fend off creditor claims. Both the Senate and House Reports accompanying the Bankruptcy Code state that the purpose of the automatic stay is to provide the debtor with "a breathing spell from his creditors." Many courts have cited this language in describing the purpose of the automatic stay.
During this breathing spell, a debtor continues to collect and accumulate money from pre-petition sales and services. Absent extraordinary circumstances, however, the debtor is not allowed to use those receipts to pay pre-petition claims until a plan of reorganization is confirmed.
While designed to benefit the debtor, the breathing spell can also have severe adverse tax consequences for the debtor. For example, a cash method debtor would be taxed on its net income in year one, which would include all revenues collected, but would not be reduced by the offsetting deductions that would normally result from the payment of pre-petition liabilities. This results in phantom income in year one for funds received which are earmarked to pay pre-petition creditor claims, but which cannot be paid due to the bankruptcy prohibition on payment prior to plan confirmation, and mismatched deductions in year two when the plan of reorganization is confirmed and the claims of creditors are paid. Thus, in many cases, if the bankruptcy debtor is not able to confirm a plan of reorganization and make creditor payments during a single tax year, the debtor's tax accounting method is distorted.