Even when the economy recovers, many businesses continue to fail. Every day we talk with S corp owners and LLC owners who are behind on MCAs and loans. They often come to us wondering what bankruptcy looks like for their business. What they do not expect is how much the tax side of the equation really matters, more than the creditors themselves. When bankruptcy makes more sense, we point them to a separate, qualified attorney. When a shareholder in an S corporation is considering bankruptcy to deal with creditors, they need to consider the tax ramifications of the bankruptcy, because the shareholders may have to pay tax on the gains even as the company is in bankruptcy. Here are five things that happen, drawn from a Tax Court case every S corporation owner should know about.
S Status
The first thing that happens is that nothing happens to your S status. You thought bankruptcy might end your S corporation? It doesn’t. The only ways an S election ends are if the shareholders revoke it, if the company has too much passive income for three years in a row, or if it no longer qualifies as an S corporation. Filing for bankruptcy isn’t on the list. Under the eligibility rules the court laid out, there must be 75 or fewer shareholders, each shareholder must be an individual, an estate, or a qualified trust, there must be no nonresident aliens among the shareholders, and there must be only one class of stock. A bankruptcy petition does not affect any of these requirements, so the court ruled the election continued in place.
The case involved Alphonse Mourad, the sole shareholder in V&M Management, an S corporation. The company filed for Chapter 11 bankruptcy in 1996, and an independent trustee was appointed. The court approved a plan in 1997. Mourad later asserted he was not a shareholder after the petition date. In the Mourad case, the Tax Court ruled that the Chapter 11 petition did not terminate the company’s S status. As long as the election is in place, the income keeps flowing to the owners’ returns.
Second, it doesn’t matter which chapter you file under. An earlier Florida case reached the same conclusion. In re Stadler Associates, the bankruptcy court held that a Chapter 7 filing did not end the S election either. A Chapter 7 and a Chapter 11 are distinguished by the remedy sought by the company in the bankruptcy, not by the tax consequences. Whatever relief the company asks the court for, the tax treatment stays the same.
Gains from Selling Company Assets
Third, gains from selling company assets still land on your return. In bankruptcy, a trustee can sell company assets. In Mourad’s case, the trustee sold the company’s primary asset for $2,872,351, producing a gain of $2,088,554. The trustee reported the gain on the company’s Form 1120S and issued a K-1 to the shareholder. The shareholder didn’t report the gain, and the IRS assessed a deficiency. A gain is a gain and it passes through. With a trustee administering the reorganization, the owner wasn’t the one making that sale, but the tax on the gain still hits your personal return, so budget for that ahead of time.
Fourth, “I didn’t get anything out of it” won’t get you out of the tax. You can’t take the advantages and pick and choose the costs. A business owner said he shouldn’t have to pay tax on a sale because he never got any benefit from it. The court said that he’d enjoyed the benefit of single taxation and pass-through of losses, and that it was fair to make him pay the tax on the pass-through gain (even though it’s painful). That is the trade-off of the S corporation: the same pass-through that once worked for you follows you into bankruptcy.
Fifth, your creditors won’t be treated as the owners. If you run a company in Chapter 11, chances are you’re insolvent. It is tempting to argue that the creditors are the company’s true owners and should report the gain. This wasn’t argued in Mourad. And it seems unlikely any court would take it, shifting the tax liability to the company’s creditors. So S shareholders should be prepared to report the gain and pay the tax on assets sold during a reorganization.
Talk to a Tax Lawyer
If your company is an S corp, figure out now what your tax liability will be if it sells its assets. Do this before the corporation files. Talk to a tax lawyer and to a bankruptcy attorney. Bankruptcy can be a good idea, but it’s also worth seeing what you can do with your creditors first. We’re a debt settlement company, not a law firm. We negotiate with funders and lenders to settle for less than the full balance. Your first consultation is free and confidential. If bankruptcy, such as Subchapter V, is the better route, we’ll tell you straight and refer you to bankruptcy counsel.
