Does bankruptcy terminate S corp status?

A business that elects to be an S corporation continues to be taxed as such until the election is terminated. It can be terminated in any of three ways: (1) The shareholders revoke the election, (2) the corporation no longer satisfies the eligibility requirements or (3) the corporation has too much passive income during the three previous tax years.

Alphonse Mourad was the sole shareholder of V&M Management, an S corporation that owned and operated a 275-unit apartment complex. In 1996 V&M petitioned for reorganization under chapter 11 of the Bankruptcy Code. To administer the reorganization, the bankruptcy court appointed an independent trustee who, in 1997, sold the apartment complex. The sale resulted in a gain of $2.l million, which was reported on V&M's 1997 form 1120S and Mourad's 1997 schedule K-1. Mourad did not file a tax return for 1997, the IRS issued him a notice of deficiency for that year and he, in turn, petitioned the Tax Court for relief.

Mourad argued the gain should have been reported by V&M, not by him, since V&M's filing for bankruptcy had terminated its status as an S corporation. The Tax Court disagreed (see Mourad v. Commissioner, 121 TC no. 1). The Tax Court held that a bankruptcy proceeding conducted under chapter 11 did not end S corporation status. Its finding was similar to that in an earlier case, In re Stadler Associates, Inc, 186 Bankr. 762, in which a bankruptcy court decided a petition under chapter 7 of the bankruptcy laws had not terminated S corporation status. In Stadler the court said that, if it permitted a bankruptcy to end S corporation status, it would be adding a fourth way or S corporation termination not specified in the tax code.

Mourad also argued it was unfair to tax him on the income of the property during the bankruptcy proceeding since he had received no benefit from it during that time. The court disagreed with this as well, saying Mourad had single taxation before the bankruptcy and also had benefited later, since the proceeds from the sale of the property reduced the liabilities of V&M for which he was personally responsible. Mourad appealed the decision to the First Circuit Court of Appeals.

Result. For the IRS. The taxpayer reiterated that V&M's S corporation status ended when it entered bankruptcy proceedings but now used the argument that V&M no longer met the eligibility requirements under the Internal Revenue Code. He said when the trustee took control of V&M the corporate creditors were, in essence, the new owners. Since these new owners were not individuals, V&M no longer was an eligible corporation and its S corporation status was terminated. He also argued that another class of stock had been created because the "new owners" had rights and preferences different from his; therefore V&M was no longer an eligible corporation.

The appellate court rejected these arguments, saying the trustee was more like the management of V&M and that neither the trustee nor the creditors took the place of the taxpayer as the sole shareholder. It said the law states any income in a bankruptcy case should be "taxed only as though such case had not been commenced." The court agreed with the Tax Court that none of the three ways the tax code laid out for terminating an S corporation applied in tiffs case. The court also could find no shareholders with different rights from the taxpayer's. This case emphasizes that a bankruptcy proceeding under Chapter 11 does not affect the S corporation status of an entity.

* Alphonse Mourad v. Commissioner, 387 F3d 27.

Prepared by Charles J. Reichert, CPA, professor of accounting, University of Wisconsin, Superior.