The Effect of Bankruptcy on a Subchapter S Election
By Marvin Kirsner, Greenberg Traurig
From The Bankruptcy Strategist, September 2003
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
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| Marvin Kirsner |
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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 (a "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 a 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, 2003). 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, nor 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 a 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 that 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 its 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.
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.
Precautions
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
can not be made for another five 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.
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