Tax Implications for S Corporations Filing for Bankruptcy by Richard E. Cabrera, CPA, JD, LLM
Just as business owners must consider the tax implications of their companies’ legal structures before beginning operations, special care should be taken to address these issues on a consistent basis throughout the organization’s lifecycle, especially before filing for bankruptcy.
According to the IRS, the majority of US corporations are structured as pass-through entities, including sole proprietorships, partnerships and S corporations, whose business income, losses and other tax items flow to its shareholders, who pay their share of the businesses’ profits at their personal income tax rates. It is important to note that S-corporation elections are simply tax designations that eliminate taxes on business profits at the entity level.
While an S corporation is considered a separate legal entity from its shareholders, a bankruptcy filing by an S Corporation will have a significant impact on its shareholders who can be liable for taxes on income made before, during and after the bankruptcy, including income generated from the sale of assets to repay creditors.
Upon a bankruptcy filing, the court imposes an automatic stay to prevent creditors from collecting debts owed to them or taking control of anything considered property of the estate. Courts have debated the matter of whether a debtor’s tax status as an S Corp is deemed property of the bankruptcy estate. In matters where the court has ruled that the S Corp status is not property of the estate, shareholders may have an opportunity to revoke or terminate an S corporation election and avoid pass-through treatment of taxes on ordinary income and gains from the sale of the entity’s assets. Revoking or terminating the S Corp status essentially converts the entity to a C corporation for income tax purposes and will trap any income and capital gains tax at the corporate level and away from shareholders.
The challenge with this strategy comes down to when the S Corp shareholder should revoke or terminate the S corporate status. There are a range of tax outcomes depending on whether the S Corp is converted prior to the bankruptcy filing, immediately after the bankruptcy filing, or during the subsequent bankruptcy proceedings. Moreover, there may be a difference between the calendar year when the bankruptcy filing occurs and the eventual sale of the debtor’s assets, which can result in a shift of the tax liabilities between the shareholder and the corporation. Therefore, it is important to evaluate the possibilities and calculate potential tax outcomes prior to initiating bankruptcy filings.
About the Author: Richard E. Cabrera, CPA, JD, LLM, is a director of Tax Services with Berkowitz Pollack Brant Advisors + CPAs, where he provides tax planning, consulting, and mergers and acquisition services to businesses and their owners located in the U.S. and abroad. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or info@bpbcpa.com.
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