Bankruptcy Estate, Not Shareholders, Liable for Taxes from Sale of S Stock.

(Parker Tax Publishing June 2016)

A bankruptcy court held that taxes due as the result of the sale of S corporation stock was a liability of the bankruptcy estate and not a liability of the debtors who had owned the stock. In re Medley, 2016 PTC 173 (Bankr. M.D. Ala. 2016).

In late 2013, involuntary bankruptcy petitions under chapter 7 were begun in an Alabama bankruptcy court against Guy Medley and his son, Michael Medley. In early 2014, the court confirmed Michael and Guy as debtors under chapter 7, and entered orders of relief. As of the date of the bankruptcies, both Guy and Michael owned shares of stock in an S corporation, Citizens Southern BancShares (BancShares). BancShares was a holding company for Citizens State Bank. BancShares issued K-1s to Guy and Michael reflecting passive income attributable to them for their ownership of the stock during calendar year 2014. Those K-1's resulted in additional tax liability for Guy and Michael for 2014.

Also, as of the date of the bankruptcies, both Guy and Michael had pledged their shares of stock in BancShares to AlaStar, a creditor, as security for a loan. Ultimately, and for the benefit of the bankruptcy estate, the bankruptcy trustee sold the BancShares stock.

When an individual files for bankruptcy, the individual's property becomes the property of the bankruptcy estate. There is no requirement that an S corporation's tax year close when a bankruptcy petition is filed by an individual S shareholder. Income or loss of the S corporation continues to be allocated among shareholders on a pro rata basis. Accordingly, the debtors and the bankruptcy estate each report a pro rata share of income or loss from the corporation in the year the bankruptcy petition is filed.

Code Sec. 1398 and Code Sec. 1399 address taxation in bankruptcy and define the division of responsibilities for the payment of taxes between the estate and the debtor on a chapter-by-chapter basis. Code Sec. 1398 provides that when an individual debtor files for Chapter 7 or 11 bankruptcy, the estate is liable for taxes. In such cases, the trustee files a separate return on the estate's behalf and the tax on the taxable income is paid by the trustee. Code Sec. 1399 provides that, except in any case to which Code Sec. 1398 applies, no separate taxable entity results from the commencement of a bankruptcy case.

Observation: In involuntary bankruptcy cases, the case "commences" for the purposes of Code Sec. 1398 once the court enters orders for relief, and not merely upon the filing of the petition.

Under the general rule of Code Sec. 1398(d)(1), the tax year of a debtor is determined without regard to the debtor's bankruptcy case. However, under Code Sec. 1398(d)(2), a debtor may elect to treat his or her tax year, which include the commencement date of the bankruptcy petition, as two taxable years: (1) the first of which ends on the day before the commencement date; and (2) the second of which begins on the commencement date. This is often referred to as the "short year election."

Neither Guy nor Michael made a timely election under Code Sec. 1398 to bifurcate the 2014 tax year. The trustee argued that because they failed to make elections under Code Sec. 1398(d)(2), Guy and Michael were responsible for the 2014 taxes arising from their stock ownership in BancShares. Because Guy and Michael did not make the Code Sec. 1398(d)(2) election, the trustee maintained that the liability for the entire 2014 tax year was treated as a post-petition debt for which liability could not attach to the bankruptcy estate; it could only attach to the debtors.

The bankruptcy court held that the trustee was responsible for the taxes arising from the income attributable to the S corporation stock ownership for the 2014 tax year. The court noted that the trustee was correct that, under Code Sec. 1398(d)(2), an individual chapter 7 debtor could elect to treat the year in which bankruptcy is begun as two taxable short years. However, the court said, under the statutory scheme, the consequence of a debtor making the Code Sec. 1398(d)(2) election is to allow the taxing authority to make a claim against the bankruptcy estate for any tax liability arising in the first short year.

According to the court, once Guy and Michael were adjudicated bankrupts in early 2014, their property and property interests, with certain exceptions not applicable in the instant case, became the property of their respective bankruptcy estates. Therefore, as of the commencement of the bankruptcy cases, the bankruptcy estate was the owner of Guy and Michael's stock in the S corporation.

The court looked at Code Sec. 1398(e)(1), which addresses how income is allocated between an individual debtor and the bankruptcy estate. Under that section of the Tax Code, the court said, the bankruptcy estate is entitled to the individual debtor's income or loss from the bankruptcy commencement date while any items of income or loss received or accrued before the bankruptcy filing remain with the debtor. Accordingly, the court determined the bankruptcy estates of Guy and Michael were entitled to any income from their S corporation stock after they were adjudicated bankrupt. Further, because the income or loss of an S corporation is determined as of the last day of the corporation's tax year and Guy and Michael filed for bankruptcy before the last day of the S corporation's tax year, gains or losses of the corporation for the year flow through in their entirety to the bankruptcy estate pursuant to Code Sec. 1366(a)(1). Thus, the court concluded that the K-1's provided to Guy and Michael should have been provided to the trustee of their bankruptcy estates and the trustee was responsible for the taxes arising from the income attributable to the S corporation stock ownership for 2014.

For a discussion of the effect of a bankruptcy petition on the reporting of S corporation income and losses, see Parker Tax ¶34,535.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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