The Effect of Bankruptcy on a Subchapter S Election

After a C Corp. pays its tax liability, and distributes profits to its shareholders in the form of a dividend, the shareholders are subject to an additional level of tax. The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the top tax that an individual pays on dividends to a maximum rate of 15%. Even with this reduced tax rate on dividends, this double tax problem still is quite costly. Prior to the 2003 Tax Act, dividends were taxed at the tax rate of the individual receiving the dividends, which could go as high as 38.6%. This current 15% tax rate on dividends is scheduled to expire in 2009, at which time the tax rate on dividends will increase to the taxpayer's regular marginal tax rate. When state individual income tax is also taken into account, the total tax rate at the individual level can exceed 23%.

How a Subchapter S Works

By filing a Subchapter S election, the S Corp. avoids this double tax problem. The income of the S Corp. is not taxed at the corporate level, but flows through to the shareholders, and the shareholders pay a single level of income tax based on their proportionate share of the S Corp.'s income.

Although the Subchapter S election works to the benefit of the shareholders of an S Corp., this benefit can turn into a major disadvantage when the S Corp files for bankruptcy protection. When an S Corp. files for bankruptcy protection, it is very possible that the shareholders will not see any more income or any other economic benefit from their ownership interest in the S Corp. However, post-petition taxable income of the S Corp./debtor would still flow through to the shareholders, which would result in a tax liability to the shareholders with no economic benefit of ownership, because the income flows through to the shareholders even though the income is not distributed.

As a simple example of how a Subchapter S election can result in negative tax consequences to its shareholders, assume that an S Corp./debtor in bankruptcy owns a single asset, a commercial rental property, with a fair market value of $2 million, a mortgage of $2 million, and a tax basis of $1 million. If the property were sold for its fair market value (or foreclosed by the mortgage holder), there would be a taxable gain of $1 million. This gain would flow through to the shareholders, who would be required to report this gain on their return, and pay the resulting tax obligation. If, however, the debtor were a C Corp., then the tax would be an obligation of the estate.

Accordingly, it is often to the advantage of a shareholder of an S Corp. for the Subchapter S status of a corporation to be terminated when it enters into bankruptcy if the S Corp./debtor will have post-petition income. Conversely, it is to the benefit of the estate to retain the Subchapter S status, because the shareholders are responsible for the taxes resulting from the post petition income of the S Corp. Note that if the S Corp./debtor will have post-petition tax losses, then it may likely be to the shareholders benefit to retain the Subchapter S election, because the losses will flow through to the shareholders, possibly allowing them to use these losses to off set other income.

Can the Election Be Revoked?

Surprisingly, the question of whether an S Corp.'s Subchapter S election is revoked upon the filing of a bankruptcy petition was not adequately addressed prior to a recent Tax Court case, Mourad v. Commissioner 121 T.C. No. 1, decided July 2, 2000. Although this issue had been addressed previously by the Bankruptcy Court for the Middle District of Florida in the Chapter 7 case of Stadler Associates (76 AFTR 2d 95-5619), it had never been addressed by the U.S. Tax Court, or in the context of a Chapter 11 case.

In Mourad, the U.S. Tax Court ruled that a Chapter 11 filing by an S Corp. does not terminate the S Corp./debtor's Subchapter S election. In Mourad, the S Corp./debtor owned an apartment building, and filed under Chapter 11. During the course of the Chapter 11 case, the apartment building was sold, resulting in a taxable gain of $2,088,554. The trustee filed an IRS Form 1120-S on behalf of the S Corp./debtor, showing the taxable gain, and sent a form K-1 to the sole shareholder, showing that all of the taxable income flowed through to the shareholder. The shareholder failed to report this income on his income tax return. The IRS assessed a tax deficiency, and the shareholder filed a case in the U.S. Tax Court to challenge the IRS position. The shareholder claimed that the filing terminated the Subchapter S election, so that the gain from the post-petition sale of the S Corp./debtor's apartment building did not flow through to him. The Tax Court held that the filing of a petition did not terminate the Subchapter S election, or create a separate taxable entity. As a result, the tax liability for the S Corp./debtor's post petition income was not a liability of the estate, and the shareholder was liable for the payment of the resulting tax obligation.

Terminating an Election

The Shareholders of an S Corp. might want to consider other ways to terminate a Subchapter S election prior to a bankruptcy petition filing by the corporation. The Internal Revenue Code allows an S Corp. to voluntarily terminate its Subchapter S election by filing a revocation of the election with the Internal Revenue Service. The revocation of a Subchapter S election is considered an irrevocable election by the Internal Revenue Code. However, the Bankruptcy Appeals Panel for the 9th Circuit held that the filing of a revocation of a Subchapter S election by an S Corp./debtor is a transfer of property that can be set aside by the trustee. See Parker v. Saunders 82 AFTR 2d 98-6877. The court reasoned that the Subchapter S election created a right in the S Corp./debtor not to be subject to income taxation, and that such an election is a property right. The court further reasoned that the S Corp./debtor's affirmative revocation of its Subchapter S election was a transfer of this property right, which allowed the trustee to set aside the otherwise irrevocable revocation. Accordingly, any voluntary revocation of an S Corp/debtor's election might very well be set aside by the trustee. The Trustee is certainly motivated to have such a revocation set aside so that the assets of the estate are not diminished by the tax obligations resulting from the S Corp./debtor's post petition income.

An alternative method that the shareholders of an S Corp. might consider to terminate a Subchapter S election prior to filing a petition would be to transfer the stock of the S Corp./debtor to an entity that is not an eligible S Corp. shareholder. The Subchapter S rules provide that only certain persons or entities can be a shareholder of an S Corp. An eligible individual shareholder must be either a U.S. citizen or a U.S. resident. Certain other entities can be a shareholder, such as a charitable organization, a pension plan and certain trusts. However, a non-resident alien, another corporation or a partnership is not an eligible S corporation shareholder. If any shares of an S Corp. are transferred to an ineligible S Corp. shareholder, the Subchapter S election is automatically terminated.

Although it has not yet been tested by the courts, the shareholders of an S Corp. who desire to terminate the Subchapter S election prior to filing a bankruptcy petition might consider transferring some of their shares to an ineligible S Corp. shareholder. If the shareholder making the transfer of shares in the S Corp./debtor is not also in bankruptcy, it would be difficult for the trustee to argue that such a transfer can be set aside, because it is the shareholder, and not the S Corp./debtor, who is making the transfer of shares. Again, in Parker v. Saunders, the court set aside the voluntary revocation of the S election by the S Corp./debtor. It was the voluntary action taken by the S Corp. that was treated by the Bankruptcy Court as the transfer of a property right that could be avoided. In the case of a transfer of shares by the shareholders of an S Corp./ debtor, this would involve an action over which the S Corp./debtor has no control. However, it should be noted that the courts have given trustees great latitude in setting aside actions which are considered as irrevocable under the Internal Revenue Code, and it is quite possible that a court might develop a theory that would allow the trustee to set aside such a transfer of shares by the shareholder of an S Corp./debtor.

Precautions

Before considering such a strategy, the shareholders should carefully review all corporate documentation, including in the Articles of Incorporation, By-Laws and any Shareholder Agreements to make certain the S Corp./debtor has no rights to control the transfer of shares in the corporation. For example, many shareholder agreements provide a right of first refusal to the corporation before shares can be transferred to a third party. In a situation where such an agreement exists, the trustee or creditors committee would likely be able to successfully argue that the transfer of the shares in violation of the S Corp./debtor's rights under the agreement can be set aside.

Before taking steps to terminate a Subchapter S election, consideration should be given to the tax cost that might arise if the S Corp./debtor emerges from bankruptcy. Once a Subchapter S election is terminated, a new election cannot be made for another 5 years. This might cause future double tax problems that could be greater than the tax burden created by income of an S Corp./debtor flowing through to the shareholders during the bankruptcy. Accordingly, a careful review of the benefits and disadvantages of a termination of a Subchapter S election should be performed by tax advisors prior to taking any such action.

Conclusion

This tax issue will likely see more litigation as more S Corps file bankruptcy petitions. Although the recent tax case of Mourad v. Commissioner was a case of first impression, this likely would not be the last such reported case dealing with termination of the Subchapter S election of an S Corp. that has filed for bankruptcy.

A new tax case from the U.S. Tax Court addresses the question of whether the filing of a Chapter 11 case by a Subchapter S corporation terminates the company's Subchapter S election. This case is important to the shareholders of a Subchapter S corporation that might have post-petition taxable income.

Background

Most closely held corporations have filed Subchapter S elections for sound tax planning purposes. A Subchapter S corporation (S Corp.) is generally not subject to an income tax at the corporate level. Rather, the shareholders pay tax on the S Corp.'s income. On the other hand, a corporation that has not filed the Subchapters S election is governed by Subchapter C of the Internal Revenue Code (C Corp.). A C Corp. is subject to federal corporate income tax at the corporate level, at rates up to 35%. The marginal tax rate for a C Corp. climbs rapidly to 34% for taxable income of over $75,000, so the top tax rate kicks in at much lower income bracket than for an individual. In addition to the federal tax, states also impose their own corporate income tax. The combined federal and state tax can result in a combined tax rate of over 40% in some states. Furthermore, a C Corp. does not get the benefit of the 15% tax rate on long-term capital gains available to individuals.

After a C Corp. pays its tax liability, and distributes profits to its shareholders in the form of a dividend, the shareholders are subject to an additional level of tax. The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the top tax that an individual pays on dividends to a maximum rate of 15%. Even with this reduced tax rate on dividends, this double tax problem still is quite costly. Prior to the 2003 Tax Act, dividends were taxed at the tax rate of the individual receiving the dividends, which could go as high as 38.6%. This current 15% tax rate on dividends is scheduled to expire in 2009, at which time the tax rate on dividends will increase to the taxpayer's regular marginal tax rate. When state individual income tax is also taken into account, the total tax rate at the individual level can exceed 23%.

How a Subchapter S Works

By filing a Subchapter S election, the S Corp. avoids this double tax problem. The income of the S Corp. is not taxed at the corporate level, but flows through to the shareholders, and the shareholders pay a single level of income tax based on their proportionate share of the S Corp.'s income.

Although the Subchapter S election works to the benefit of the shareholders of an S Corp., this benefit can turn into a major disadvantage when the S Corp files for bankruptcy protection. When an S Corp. files for bankruptcy protection, it is very possible that the shareholders will not see any more income or any other economic benefit from their ownership interest in the S Corp. However, post-petition taxable income of the S Corp./debtor would still flow through to the shareholders, which would result in a tax liability to the shareholders with no economic benefit of ownership, because the income flows through to the shareholders even though the income is not distributed.

As a simple example of how a Subchapter S election can result in negative tax consequences to its shareholders, assume that an S Corp./debtor in bankruptcy owns a single asset, a commercial rental property, with a fair market value of $2 million, a mortgage of $2 million, and a tax basis of $1 million. If the property were sold for its fair market value (or foreclosed by the mortgage holder), there would be a taxable gain of $1 million. This gain would flow through to the shareholders, who would be required to report this gain on their return, and pay the resulting tax obligation. If, however, the debtor were a C Corp., then the tax would be an obligation of the estate.

Accordingly, it is often to the advantage of a shareholder of an S Corp. for the Subchapter S status of a corporation to be terminated when it enters into bankruptcy if the S Corp./debtor will have post-petition income. Conversely, it is to the benefit of the estate to retain the Subchapter S status, because the shareholders are responsible for the taxes resulting from the post petition income of the S Corp. Note that if the S Corp./debtor will have post-petition tax losses, then it may likely be to the shareholders benefit to retain the Subchapter S election, because the losses will flow through to the shareholders, possibly allowing them to use these losses to off set other income.

Can the Election Be Revoked?

Surprisingly, the question of whether an S Corp.'s Subchapter S election is revoked upon the filing of a bankruptcy petition was not adequately addressed prior to a recent Tax Court case, Mourad v. Commissioner 121 T.C. No. 1, decided July 2, 2000. Although this issue had been addressed previously by the Bankruptcy Court for the Middle District of Florida in the Chapter 7 case of Stadler Associates (76 AFTR 2d 95-5619), it had never been addressed by the U.S. Tax Court, or in the context of a Chapter 11 case.

In Mourad, the U.S. Tax Court ruled that a Chapter 11 filing by an S Corp. does not terminate the S Corp./debtor's Subchapter S election. In Mourad, the S Corp./debtor owned an apartment building, and filed under Chapter 11. During the course of the Chapter 11 case, the apartment building was sold, resulting in a taxable gain of $2,088,554. The trustee filed an IRS Form 1120-S on behalf of the S Corp./debtor, showing the taxable gain, and sent a form K-1 to the sole shareholder, showing that all of the taxable income flowed through to the shareholder. The shareholder failed to report this income on his income tax return. The IRS assessed a tax deficiency, and the shareholder filed a case in the U.S. Tax Court to challenge the IRS position. The shareholder claimed that the filing terminated the Subchapter S election, so that the gain from the post-petition sale of the S Corp./debtor's apartment building did not flow through to him. The Tax Court held that the filing of a petition did not terminate the Subchapter S election, or create a separate taxable entity. As a result, the tax liability for the S Corp./debtor's post petition income was not a liability of the estate, and the shareholder was liable for the payment of the resulting tax obligation.

Terminating an Election

The Shareholders of an S Corp. might want to consider other ways to terminate a Subchapter S election prior to a bankruptcy petition filing by the corporation. The Internal Revenue Code allows an S Corp. to voluntarily terminate its Subchapter S election by filing a revocation of the election with the Internal Revenue Service. The revocation of a Subchapter S election is considered an irrevocable election by the Internal Revenue Code. However, the Bankruptcy Appeals Panel for the 9th Circuit held that the filing of a revocation of a Subchapter S election by an S Corp./debtor is a transfer of property that can be set aside by the trustee. See Parker v. Saunders 82 AFTR 2d 98-6877. The court reasoned that the Subchapter S election created a right in the S Corp./debtor not to be subject to income taxation, and that such an election is a property right. The court further reasoned that the S Corp./debtor's affirmative revocation of its Subchapter S election was a transfer of this property right, which allowed the trustee to set aside the otherwise irrevocable revocation. Accordingly, any voluntary revocation of an S Corp/debtor's election might very well be set aside by the trustee. The Trustee is certainly motivated to have such a revocation set aside so that the assets of the estate are not diminished by the tax obligations resulting from the S Corp./debtor's post petition income.

An alternative method that the shareholders of an S Corp. might consider to terminate a Subchapter S election prior to filing a petition would be to transfer the stock of the S Corp./debtor to an entity that is not an eligible S Corp. shareholder. The Subchapter S rules provide that only certain persons or entities can be a shareholder of an S Corp. An eligible individual shareholder must be either a U.S. citizen or a U.S. resident. Certain other entities can be a shareholder, such as a charitable organization, a pension plan and certain trusts. However, a non-resident alien, another corporation or a partnership is not an eligible S corporation shareholder. If any shares of an S Corp. are transferred to an ineligible S Corp. shareholder, the Subchapter S election is automatically terminated.

Although it has not yet been tested by the courts, the shareholders of an S Corp. who desire to terminate the Subchapter S election prior to filing a bankruptcy petition might consider transferring some of their shares to an ineligible S Corp. shareholder. If the shareholder making the transfer of shares in the S Corp./debtor is not also in bankruptcy, it would be difficult for the trustee to argue that such a transfer can be set aside, because it is the shareholder, and not the S Corp./debtor, who is making the transfer of shares. Again, in Parker v. Saunders, the court set aside the voluntary revocation of the S election by the S Corp./debtor. It was the voluntary action taken by the S Corp. that was treated by the Bankruptcy Court as the transfer of a property right that could be avoided. In the case of a transfer of shares by the shareholders of an S Corp./ debtor, this would involve an action over which the S Corp./debtor has no control. However, it should be noted that the courts have given trustees great latitude in setting aside actions which are considered as irrevocable under the Internal Revenue Code, and it is quite possible that a court might develop a theory that would allow the trustee to set aside such a transfer of shares by the shareholder of an S Corp./debtor.

Precautions

Before considering such a strategy, the shareholders should carefully review all corporate documentation, including in the Articles of Incorporation, By-Laws and any Shareholder Agreements to make certain the S Corp./debtor has no rights to control the transfer of shares in the corporation. For example, many shareholder agreements provide a right of first refusal to the corporation before shares can be transferred to a third party. In a situation where such an agreement exists, the trustee or creditors committee would likely be able to successfully argue that the transfer of the shares in violation of the S Corp./debtor's rights under the agreement can be set aside.

Before taking steps to terminate a Subchapter S election, consideration should be given to the tax cost that might arise if the S Corp./debtor emerges from bankruptcy. Once a Subchapter S election is terminated, a new election cannot be made for another 5 years. This might cause future double tax problems that could be greater than the tax burden created by income of an S Corp./debtor flowing through to the shareholders during the bankruptcy. Accordingly, a careful review of the benefits and disadvantages of a termination of a Subchapter S election should be performed by tax advisors prior to taking any such action.

Conclusion

This tax issue will likely see more litigation as more S Corps file bankruptcy petitions. Although the recent tax case of Mourad v. Commissioner was a case of first impression, this likely would not be the last such reported case dealing with termination of the Subchapter S election of an S Corp. that has filed for bankruptcy.