Bankruptcy and S corporation pass-through.

Although there are some signs the economy is improving, many businesses continue to fail. Recently the Tax Court considered the effect of an S corporation's selling an asset while in bankruptcy. All S corporation shareholders contemplating filing for corporate bankruptcy need to consider the potential tax outcome of such a move.

Alphonse Mourad was the sole shareholder of V&M Management Inc., an S corporation. On January 8, 1996, the corporation filed a Chapter 11 bankruptcy reorganization petition. The court appointed an independent trustee to administer the reorganization. On September 26, 1997, the court approved the plan. The trustee sold the corporation's main asset for $2,872,351, realizing a gain of $2,088,554. The trustee reported the gain on form 1120S and sent a form K-1 to the shareholder. Mourad did not report the gain as income and the IRS determined a deficiency. He later claimed he should not be treated as the shareholder of an S corporation following V&M's bankruptcy petition. Mourad also argued he should not have to report the gain because he did not benefit from the sale.

Result. For the IRS. The general rule is that following a valid S election, shareholders must report and pay tax on the corporation's income. This system of taxation continues until the S election terminates. A company's S corporation status can end in any of three ways:

* Shareholders voluntarily revoke the entity's S corporation status.

* The corporation has excessive passive income for three consecutive years.

* The corporation ceases to be a small business corporation that is eligible for S status. The first two circumstances did not apply to this case. Therefore, the court addressed whether the corporation had stopped being eligible for S status.

To be eligible for S corporation status, a corporation cannot have

* More than 75 shareholders.

* A shareholder that is other than an individual, estate or qualified trust.

* A nonresident alien shareholder.

* More than one class of stock outstanding.

Filing a bankruptcy petition--as V&M Management did--did not violate any of the above requirements. Therefore, according to the court, the company's S election was not terminated.

As additional support, the court referred to a prior case, In re Stadler Associates Inc., in which the Florida bankruptcy court held that filing a bankruptcy petition did not terminate an S election. Although Stadler involved a Chapter 7 bankruptcy and Mourad Chapter 11, the result was the same. The differences between the two filings were in the remedies the companies sought, not the tax treatment. The court ruled that V&M's S corporation status was still in effect and that Mourad should have included his share of the gain in income.

In rejecting Mourad's contention that he shouldn't be taxed on the gain because he didn't benefit from the property's sale, the court noted that the taxpayer previously had benefited from the single taxation of the company's income and the pass-through of losses. Therefore, he now had to pay tax on the pass-through gain from the sale of the entity's property, even though the taxation would be detrimental to him. The result, according to the court, would be equitable.

There was one concern the case did not raise, and therefore, the court did not deal with it. Since the corporation filed a bankruptcy reorganization plan, it likely was insolvent. In that case it could be argued the creditors were the de facto shareholders and should have reported the gain. However, it isn't likely any court would have accepted this argument and sifted the tax to the creditors. As a result all S shareholders should be prepared to report and pay tax on any gains from asset sales during a bankruptcy reorganization.

* Alphonse Mourad v. Commissioner, 121 TC no. 11.

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.