S Corp Bankruptcy: 5 Tax Consequences That Land on the Shareholder

An S corporation that files bankruptcy keeps its shareholders on the hook for its tax results, because the tax code creates no new taxpayer when a corporation's case begins. The company still files its return; its items still pass through to the owners on Schedule K-1; and several rules written for the discharge of debt apply at the corporate level in ways that leave the shareholder with the bill, the lost deduction, or both.

The five consequences below concern federal income tax only and describe the statutes, not any company's return. The shareholder's tax adviser should see the bankruptcy papers early, well before the first K-1 of the case arrives.

1. The Trustee's Sales Still Report to the Shareholders

Section 1399 of the Internal Revenue Code is a single sentence: "Except in any case to which section 1398 applies, no separate taxable entity shall result from the commencement of a case under title 11." Section 1398 covers only individuals in Chapter 7 or 11. A corporation's bankruptcy therefore produces no estate that pays its own tax, and the corporation remains the taxpayer.

Someone must still prepare the return. Where a trustee holds all or substantially all of a corporation's property, 26 U.S.C. 6012(b)(3) directs that the trustee "shall make the return of income for such corporation in the same manner and form as corporations are required to make such returns." For an S corporation that is Form 1120-S, and the IRS's closing checklist asks the corporation to check the "final K-1" box in the year the company closes.

The effect on shareholders is where the owners feel it. Under section 1366(a), each shareholder takes into account a pro rata share of the corporation's items of income, loss and deduction, and section 1366(b) preserves their character "as if such item were realized directly from the source from which realized by the corporation." When a Chapter 7 trustee sells the equipment, the building or the customer list, any gain on the sale is the corporation's gain, and so it becomes the shareholders' gain on their own returns. The sale proceeds go to creditors.

The trustee sells the assets and pays the creditors. The shareholders report the gain.

Consider a hypothetical corporation whose fully depreciated equipment the trustee sells for $60,000. Every dollar goes to the secured lender. The gain, measured against a tax basis near zero, passes through to the two equal shareholders, $30,000 each, on returns they file with money the bankruptcy did not give them. Whether depreciation recapture or other rules change the character of that gain is a question the company's accountant answers with the asset records in hand, and it is a question worth raising before the sale motion rather than after.

2. Forgiven Debt Is Excluded at the Corporation's Door, Not the Shareholder's

A discharge of the corporation's debt in bankruptcy is excluded from income under section 108(a)(1)(A), and section 108(d)(7)(A) fixes where that exclusion operates: "In the case of an S corporation, subsections (a), (b), (c), and (g) shall be applied at the corporate level, including by not taking into account under section 1366(a) any amount excluded under subsection (a)." The excluded amount never passes through.

That cuts two ways. The shareholder is not taxed on the forgiven balance, which is the benefit. The shareholder also gains no stock basis from it, and a shareholder's own insolvency is irrelevant to the exclusion, because the test belongs to the corporation. Owners who remember advice from a partnership or a sole proprietorship, where the rules sit elsewhere, sometimes assume otherwise.

3. Losses the Shareholder Could Not Yet Use Are Spent First

A shareholder can deduct S corporation losses only up to the shareholder's basis in stock and in loans made to the corporation, under section 1366(d)(1), and losses above that limit carry forward indefinitely as though incurred by the corporation in the next year with respect to that shareholder. Many owners of a failing company have exactly such a stack of suspended losses, waiting for basis that never came.

The exclusion under section 108 is paid for by reducing tax attributes, and section 108(d)(7)(B) adds those suspended losses to the list. For the year of the discharge, a shareholder's loss disallowed under section 1366(d)(1) "shall be treated as a net operating loss for such taxable year," which puts it among the first attributes the excluded amount reduces. The deduction the owner was saving can disappear in the same year the debt does. There are elections and ordering rules that affect how much, though they belong to the tax adviser.

4. The Stock Becomes a Loss, Usually a Capital One

When the shares become worthless, section 165(g) treats the loss as if the stock had been sold on the last day of the taxable year, which makes it a capital loss for most shareholders. Section 1244 offers an exception for individuals who received qualifying stock of a small business corporation for money or property: the loss can be ordinary, up to $50,000 a year, or $100,000 on a joint return. Whether the shares qualify depends on how and when they were issued. The year of worthlessness is a factual question in its own right, and owners who claim it too early or too late tend to hear about it.

5. Withheld Payroll Taxes Follow the Officer, Not the Stock

The trust fund recovery penalty under section 6672 attaches to a responsible person who willfully failed to pay over taxes withheld from employees, in an amount equal to the unpaid trust fund tax. It is personal, it is independent of share ownership, and the corporation's bankruptcy leaves it where it was. For the shareholder who also signed the payroll checks, this is often the largest number of the five.

Settlement Outside the Courthouse Is Tested the Same Way

A negotiated reduction of the corporation's debt outside bankruptcy produces the same kind of canceled-debt income, and the same corporate-level rule applies, except that the exclusion then depends on the corporation's insolvency and stops at the amount of it. Delancey Street negotiates merchant cash advance and related balances for businesses, including S corporations. Not a law firm and not a tax adviser, the company gives no legal or tax opinions, and its first review of a file costs nothing and is kept confidential. Where the question is the tax cost of a settlement against the tax cost of a plan, the accountant belongs in the conversation from the first call, and the owner should expect the answer to come back in the owner's own name.