Net Operating Losses, S Corporations, and Shareholder Bankruptcy
Landau, Zev, The CPA Journal
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.
The 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.
This 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;
* The computation of the estate's taxable income;
* Accounting methods and periods;
* The treatment of the estate's administration costs as deductible expenses;
* The carryover of tax attributes between the debtor and the estate; and
* Requirements for filing and disclosure of returns.
The 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.
Williams v. Comm'r
A first 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 S 1, but despite that financing, S1 and S2 reported losses of $3.4 million and $155,000, respectively, in 1990.
Williams 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 day."
Williams 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).
One 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.
Williams 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. …