Operating Losses, S Corporations, and Shareholder Bankruptcy
MAY 2005 - A
bankruptcy estate is created when an individual files a Chapter
7 or Chapter 11 petition. The estate is a separate entity
for purposes of both bankruptcy law and tax law. According
to IRC section 1398, the estate succeeds to all legal and
equitable interests and certain tax attributes of the debtor.
Bankruptcy Tax Act of 1980 amended the IRC to exclude from
gross income amounts of indebtedness that are discharged
either pursuant to bankruptcy, outside of bankruptcy when
the taxpayer is insolvent (only to the extent of such insolvency),
or in certain cases of business indebtedness. It required
the taxpayer either to elect to reduce the basis of depreciable
assets by the amount of indebtedness discharge, or to reduce
specified tax attributes by the amount of such discharge.
The first tax attributes that had to be reduced were current
and carryover net operating losses.
legislation treated the bankruptcy estate of an individual
in a liquidation or reorganization case as a separate taxable
entity for federal income tax purposes. It also set rules
for the following:
The allocation of income and deductions between the debtor
and the estate;
computation of the estate’s taxable income;
methods and periods;
treatment of the estate’s administration costs as
carryover of tax attributes between the debtor and the
for filing and disclosure of returns.
Bankruptcy Tax Act added IRC section 1398 “to eliminate
uncertainty and litigation by detailing how federal income
tax attributes and liabilities are to be allocated between
the bankruptcy estate and the individual debtor.”
Title 11, Chapter 5, Subchapter III, describes what is considered
the property of the estate in a bankruptcy proceeding. Section
1398 specifies whether the bankruptcy estate or the individual
debtor reports income, deductions, and credits, and when
either taxpayer succeeds to the tax attributes of the other.
reading of the facts in the case of Lawrence G. Williams
(123 T.C. No. 8) leaves the impression that he was
correct in reporting losses from S corporations on his 1990
personal tax return. Until December 3, 1990, he was the
sole owner of two S corporations, S1 and S2. He used a $4
million loan to finance the operations of S1, but despite
that financing, S1 and S2 reported losses of $3.4 million
and $155,000, respectively, in 1990.
and his tax advisers relied on IRC section 1377 and relevant
regulations for guidance on how to calculate distributive
shares of an S corporation’s items when there is a
change in ownership during the year. Treasury Regulations
section 1.1377-1(a)(1) provides that “in general for
purposes of subchapter S … each shareholder’s
pro rata share of any S corporation item … is the
sum of the amounts determined with respect to the shareholder
by assigning an equal portion of the item to each day of
the S corporation’s taxable year, and then dividing
that portion pro rata among the shares outstanding on that
concluded that because he was the sole owner of S1 and S2
during 1990 for 338 days, or 92.33% of the year, it would
be appropriate to report 92.33% of the losses of both S
corporations on his personal tax return. The remainder of
the losses, 7.67%, was left to be claimed by the successor
owner (in this case, the bankruptcy estate).
important overlooked fact, however, resulted in the Tax
Court’s unfavorable decision. Williams’ ownership
was not terminated on December 3, 1990, because of a disposition,
but rather because this was the date he filed a petition
for Chapter 11 bankruptcy. There was no sale, exchange,
or gift of stock by Williams. Instead, there was a transfer
of assets, including stock in the two S corporations, to
a new legal taxable entity: his bankruptcy estate.
claimed that the transfer of his shares in S1 and S2 to
his bankruptcy estate should be treated like any other disposition
under IRC section 1377, and that he should therefore be
entitled to receive a pro rata share of each loss. The bankruptcy
proceedings, in his opinion, did not override or change
the rules for allocating income and loss to S corporation
shareholders under section 1377.
Tax Court agreed with the IRS’s position. Judge Diane
L. Kroupa stated that: “A transfer of an asset from
the debtor to the Bankruptcy Estate when the debtor files
for bankruptcy is not a disposition triggering tax consequences.”
IRC section 1398(f) states that “a transfer (other
than by sale or exchange) of an asset from the debtor to
the estate shall not be treated as a disposition for purposes
of any provision assigning tax consequences to a disposition
and the estate shall be treated as the debtor would be treated
with respect to such asset.”
was therefore wrong when he claimed that the bankruptcy
proceeding did not alter the rule for allocating income
and loss to S corporation shareholders under section 1377.
The Tax Court concluded that the bankruptcy and insolvency
provisions come first, and that the estate should have been
treated as the debtor with respect to the debtor’s
assets, including the shares in the two
S corporations. Therefore, the estate is treated as if it
had owned all the shares of S1 and S2 for the entire year.
The shareholder is not entitled to the entire loss generated
during 1990, including the loss attributable to each corporation.
Williams have claimed that his prorated share of losses
from January 1 through December 3, 1990, represented the
income or loss that he recognized or accrued before filing
for bankruptcy, and therefore that the loss should have
remained with him? The Tax Court didn’t think so.
The taxable year of each corporation ended on December 31,
1990. There was no taxable disposition, and none of the
losses were distributable to the debtor prior to December
3, 1990. Income or losses of S corporations are determined
as of the last day of the corporation’s taxable year,
and therefore the corporations’ losses flowed through
to the estate rather than to Williams.
Amount and Timing
section 1398(g)(1) states: “The estate shall succeed
to and take into account the net operating loss carryovers
and other items determined as of the first day of the debtor’s
taxable year in which the case commences.” On that
basis, Williams took the position that if the bankruptcy’s
taxable year started on December 3, 1990, the estate should
not be entitled to succeed to any loss carryovers generated
during the year in which the petitioner filed for bankruptcy,
because there was not any net operating loss carryover as
of January 1, 1990. The
judge thought the taxpayer’s interpretation was misconstrued.
IRC section 1398(g)(1) is relevant only to debtors that
have net operating losses before the bankruptcy year, making
it inapplicable in this case.
the life of the bankruptcy estate, the net operating losses
that it inherits from the debtor offset any income that
is generated until the settlement and termination of the
bankruptcy estate. The losses that the bankruptcy estate
does not use during its life are available for utilization
by the debtor.
of the settlement involved the cancellation of the companies’
borrowings. IRC section 61(a)(12) includes in gross income
any income from cancellation of debt. IRC section 108(a)(1)(A)
excludes from gross income any cancellation of debt if the
discharge occurs in a Title 11 case. IRC section 108(b)
applies the amount excluded from gross income because of
a Chapter 11 case to reduce certain tax attributes of the
debtor in a predetermined order. Any net operating loss
for the taxable year of the discharge, and any net operating
loss carryover to such taxable year, are the first attributes
that have to be reduced.
bankruptcy estate of Lawrence Williams was formed on December
3, 1990, and it carried forward net operating losses until
1997, the year in which the debt of $4 million was discharged.
The net operating loss carried forward was approximately
$3.5 million and was otherwise available to Williams upon
the estate’s termination, but that loss carryover
was eliminated because of the exclusion of $4 million of
debt cancellation from Williams’ income. Therefore
Williams could not claim any losses in 1997 or carry forward
any loss to subsequent years.
petition for bankruptcy was filed 28 days before the fiscal
year-ends of S1 and S2; if Williams had filed his petition
after December 31, 1990, he would have been able to claim
corporate losses on his personal tax returns. He was apparently
compelled to file his petition on December 3, 1990, so that
avenue of planning was not available. Taxpayers filing for
bankruptcy that can wait until after the corporate year-
end would benefit from doing so.
case brings to mind what Edward H. Levi, a scholar on legal
reasoning, said: “In an important sense, legal rules
are never clear, and if a rule could be clear before it
could be imposed, society would be impossible.”
Landau, CPA, has practiced in the field of accounting
and taxation in New York City for more than 20 years, has
served on numerous NYSSCPA industry and taxation committees,
and has written articles for The CPA Journal and
The Trusted Professional.