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Net operating losses, S corporations, and shareholder bankruptcy.

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 S1, 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 rate 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.

Prorating Issues

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. 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.

The 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."

Williams 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.

Could 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.

NOL Amount and Timing

IRC 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.

During 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.

Part 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.

The 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.

Planning Possibilities

The 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.

This 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."

Zev 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.
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Title Annotation:corporate taxation
Author:Landau, Zev
Publication:The CPA Journal
Geographic Code:1USA
Date:May 1, 2005
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