S Status Survives Bankruptcy

The First Circuit recently held that an S corporation’s filing of a bankruptcy petition and the appointment of a trustee did not automatically terminate S corporation status.

Facts

M was the sole shareholder of A, an S corporation. A sold property as part of a reorganization plan developed by an independent trustee after it filed a Chapter 11 petition for reorganization. M was assessed a nearly $200,000 income tax deficiency stemming from the sale. The Tax Court ruled that M was personally liable for the tax, because gains and losses are passed through to shareholders; see Alphonse Mourad, 121 TC 1 (2003); see also Karlinsky and Burton, “S Corporations: Current Developments (Part II),” TTA, November 2004, p. 709. It rejected the argument that the bankruptcy filing had automatically terminated A’s S election; M appealed to the First Circuit.

Analysis

A shareholder’s election of S status remains in effect until it is terminated under Sec. 1362(d), which identifies three ways a termination may occur: (1) more than 50% of the corporation’s shareholders vote to revoke the election; (2) the business ceases to be a “small business corporation”; or (3) the business’s passive investment income exceeds 50% of gross receipts for three consecutive years (and the business earned profits in each of those years).

M asserts that Sec. 1362(d)(2) is applicable here because it no longer met the requirements of a small business corporation when it entered into bankruptcy. Under Sec. 1361(b), a small business corporation must be a domestic corporation with fewer than 75 shareholders (prior to the American Jobs Creation Act of 2004), all of whom must be individuals and none of whom may be a nonresident alien, and can have only one class of stock. M argues that, because the trustee took control of the company for the benefit of its creditors, M no longer was its real owner. This left A with new shareholders—the corporate creditors—who were not individuals, and also generated more than one class of stock, because of the creditors’ “different rights and preferences.”

Although M’s equity interest in A may have been without value by the time the bankruptcy filing occurred, neither the trustee nor the creditors displaced him as sole shareholder. Bankruptcy Code Section 346(c)(1) explicitly provides that any income of the estate in a bankruptcy case “may be taxed only as though such case had not been commenced,” reinforcing the view that a Chapter 11 bankruptcy filing does not change the tax relationship between a debtor corporation and its shareholders. This conclusion is further buttressed by the scant case law that exists. In In Re Stadler Assocs., Inc., 186 BR 762 (Bankr. SD FL 1995), the sole shareholder of an S corporation that had filed a Chapter 7 petition argued that the bankruptcy filing had terminated the debtor’s S status. The bankruptcy court disagreed, holding that termination was limited to the methods in Sec. 1362(d).

Other courts, while not directly considering whether a bankruptcy filing automatically ends S status, implicitly have adopted the view in Stadler when discussing whether shareholders may choose to terminate S status under Sec. 1362(d) when anticipating a bankruptcy filing; see In Re Bakersfield Westar, Inc., 226 BR 227 (9th Cir. BAP 1998) and In Re Trans-Lines West, Inc., 203 BR 653 (Bankr. ED TN 1996). Such an inquiry would be unnecessary if bankruptcy automatically effected termination.

Although this case does not raise the question whether shareholders should be permitted to terminate S status under Sec. 1362(d) when a bankruptcy filing is imminent or has occurred, we recognize the contention that it is unfair to assess tax liability on shareholders who do not receive the income on which they are obligated to pay the tax. However, M did not attempt a statutory revocation of the S election. Moreover, the record indicates that he was personally liable for A’s debts. Thus, to the extent that the sale proceeds were applied to A’s debts, M received benefits along with the tax burden.

Thus, A remained an S corporation following its entry into bankruptcy and the tax liability on the sale was properly assessed and passed through to M.

Alphonse Mourad, 1st Cir., 10/20/04

Reflections: In In Re Forman Enters., Inc., 281 BR 600 (WD PA 2002), S shareholders were allowed to retain (1) pre-petition dividends and (2) tax refunds stemming from the use of the debtor’s pre-petition net operating losses, rather than turning them over to the Chapter 7 bankruptcy trustee for distribution to the debtor’s creditors.