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socrateaser
socrateaser, Attorney
Category: Bankruptcy Law
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Experience:  Attorney and Real Estate Broker -- Retired (mostly)
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Cancelled S corp debt create tax if personally BKd

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I own a S corp, a mortgage co. This company has been inactive, essentially defunct and not producing income for about 2 years. I was a personal guarantor on several corp credit cards and lines of credit. I included these in my personal bankruptcy as I had personally guaranteed these. Since the business has not had an income, these credit cards and lines of credit have not been paid and are in default. Now, if these creditors issue the corp a 1099 for cancelled debt, will this create taxable income for me personally, as I have already included these in my BK (an nothing was added to the credit cards in the meantime? (I know that my personal credit cards that were BK'd do not create taxable income for me even if a 1099 is issued to me. I assume it is the same with my business debts, but I don't know for sure and I haven't been able to find anyone who can answer this question definitively. I hope you can help.) Thanks for your help.
Submitted: 4 years ago.
Category: Bankruptcy Law
Expert:  socrateaser replied 4 years ago.

Tax liability for your corporation does not pass through to you, unless the government decides to try to "pierce the corporate veil" and hold you liable under the theory that the corporation was simply your alter ego and not a separate legal entity.

 

Many defunct corporations lie dormant forever, because they have no assets, and there is no resonable means for the government to collect the taxes owed.

 

Hope this helps.

 

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Customer: replied 4 years ago.
So, let me make sure I understand... I understand that you are saying that even though this is a S-corp and normally corporate income passes through to me on a Sched K-1, but since this corporate debt was included in my personal BK (because I was a guarantor for the debt for the corporation), that any associated 1099 Cancelled Debt income to the corporation will not pass through to me on my K-1 (as normal corporate income would) and will not create a personal tax liability for me. Is this correct?
Expert:  socrateaser replied 4 years ago.

Thanks for double checking, because now that I understand your concern, I see the issue more clearly.

 

You can revoke your S-Corp election under 26 CFR §1.1362-6(a)(3)(i), as follows:

 

"To revoke an election, the corporation files a statement that the corporation revokes the election made under section 1362(a). The statement must be filed with the service center where the election was properly filed. The revocation statement must include the number of shares of stock (including non-voting stock) issued and outstanding at the time the revocation is made. A revocation may be made only with the consent of shareholders who, at the time the revocation is made, hold more than one-half of the number of issued and outstanding shares of stock (including non-voting stock) of the corporation. Each shareholder who consents to the revocation must consent in the manner required under paragraph (b) of this section. In addition, each consent should indicate the number of issued and outstanding shares of stock (including non-voting stock) held by each shareholder at the time of the revocation."

 

Title 26 CFR §1.1362-2(a)(2), provides "(i) In general. Except as provided in paragraph (a)(2)(ii) of this section, a revocation made during the taxable year and before the 16th day of the third month of the taxable year is effective on the first day of the taxable year and a revocation made after the 15th day of the third month of the taxable year is effective for the following taxable year. If a corporation makes an election to be an S corporation that is to be effective beginning with the next taxable year and revokes its election on or before the first day of the next taxable year, the corporation is deemed to have revoked its election on the first day of the next taxable year.

(ii) Revocations specifying a prospective revocation date. If a corporation specifies a date for revocation and the date is expressed in terms of a stated day, month, and year that is on or after the date the revocation is filed, the revocation is effective on and after the date so specified.

 

Once the election is revoked, there is no pass-thru income. The corporation simply traps the income. If the corporation can't pay the taxes for lack of assets, then the bill will just sit there forever.



Edited by socrateaser on 11/8/2009 at 2:27 AM EST
Customer: replied 4 years ago.
I apologize for this being such a complex question, but let me make sure I understand.

Apparently, without directly stating it, you are saying that 1099 Cancelled Debt income to an S-corp is considered taxable income to the owner(s) even if that same cancelled corp debt was included in the owner's personal bankrupcty, correct?

Therefore, you are suggesting that converting the S-corp to a C-corp is a course of action that could prevent that 1099 Cancelled Debt income to be passed through to the owners, correct? This raises a couple of issues.

1) At this point, can we specify a revocation date of our "S" election that is prior to MAR 16 (this is a course of action that we have been considering but have not acted upon) so it is effective for tax year 2009? If not, then it wouldn't be effective until tax year 2010. I expect the corporation may receive several 1099s for tax year 2009. Any other remedy if this cannot be effective until 2010?

2) When is this cancelled debt considered income? Is it when the 1099 is issued? Or, is it when the debt was originally incurred? If it is when the debt was originally incurred, then the income would precede any election to revoke the "S" status.

If revocation of the "S" election won't work for the 2009 tax year to protect me from incurring personal income tax liability on these corp debts I personally bankrupted, what would be the simplest course of action to take to accomplish this end?
Expert:  socrateaser replied 4 years ago.

Don't apologize. This is a gray-area issue that I do not believe has ever been litigated.

 

1) At this point, can we specify a revocation date of our "S" election that is prior to MAR 16.

 

A: Yes. You may have missed it in my previous answer. Under 26 CFR §1.1362-6(a)(3)(ii), "If a corporation specifies a date for revocation and the date is expressed in terms of a stated day, month, and year that is on or after the date the revocation is filed, the revocation is effective on and after the date so specified."

 

2) When is this cancelled debt considered income?

 

A: COD date is the date when the debt is "charged off" by the creditor.

 

If your revocation is too late, then the issue falls into the area of nobody knows. Ordinarily, the COD income would be distributed to the S-Corp shareholders IRC §108. However, you have already discharged your personal obligation for the debt, which would have included this COD income had the creditor sought to collect against you directly.

 

But, now you receive the same income again, indirectly, only through a nonbankruptcy debt to the corporation. There's no precedent for this, as far as I"m aware, which means that a tax court would get to decide, or, you could ask the bankruptcy could to determine the outcome based on an argument that the two debts are really the same, and you've already been discharged. Either way, you suffer serious litigation costs. So, it may be better that if the revocation date is too late, to Chapter 7 the S-Corp and discharge the debt again, because that cost will likely be less than the cost of fighting with the IRS over the treatment of the COD income.

 

 

Customer: replied 4 years ago.
OK... I know that no debt was charged-off as of the beginning of 2009, so it seems that we could specify a date to revoke the "S" election very early in the year, and this should, assuming it's prior to the charge-off dates, solve the issue of the 1099 Cancelled Debt income passing through to me, the owner, correct?

Otherwise, I could either take my chances and potentially end up in litigation with the IRS or I could do a Chap-7 BK on the S-corp and BK the corp debt directly, correct?

Expert:  socrateaser replied 4 years ago.

Yes to all questions, except that you can't specify a revocation date later than the date that you file the revocation with the IRS. So, that date will be after today, no matter what.

Customer: replied 4 years ago.
So I can specify a revocation date that is prior to Mar 16, 2009 (so it would be effective to tax year 2009) but not before Jan 1, 2009 and not after the date I file the revocation with the IRS, correct?
Expert:  socrateaser replied 4 years ago.
No. The specified date of revocation must be on or after the date on which the revocation is filed with the IRS.
socrateaser, Attorney
Category: Bankruptcy Law
Satisfied Customers: 33801
Experience: Attorney and Real Estate Broker -- Retired (mostly)
socrateaser and other Bankruptcy Law Specialists are ready to help you
Customer: replied 4 years ago.
Thank you.
Expert:  socrateaser replied 4 years ago.
You're welcome, and thanks for a very interesting question.

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