Insolvant S-Corp -- dissolve or keep for 10 years for possible tax benefit?

[phoenyx]

I have a client who started an S-Corp in 2000. He initially owned 60%, but in 2004 purchased the other 40%.

The S-Corp then tanked quite hard, and is largely not operating at this point. It has about $2,000 in assets to its $300,000 in liabilities.

The majority (now 100%) shareholder was going to dissolve the S-Corp within the next few months. He was always a material participant, so there is no issue of passive income or losses.

He has a cumulative amount of disallowed/suspended losses on his 2003-2007 Form 6198's, of about an amount of $275,000. These losses were disallowed/suspended due to zero adjusted basis and no contributions.

Under advice from an IRS Individual Complex Tax Law Department representative, we thought when he dissolved the S-Corp, those losses would become current/unsuspended, create a huge loss on his Schedule E, creating a huge net operating loss which would carry forward for up to 20 years to offset future earned income.

In the thread "Unsuspend 'suspended at-risk 6198 losses'? - Stock interest terminated", several replies indicated that the IRS agent was incorrect, and that without somehow restoring basis, the disallowed/suspended losses just went away.

He is filing personal Chapter 7 bankruptcy to discharge the S-Corp debt that he personally guaranteed.


That background leads me to my question...

Should he dissolve the S-Corp?

Or, should he leave it open and completely unoperating? What if he does this, and waits for the statute of limitations to run out on all the S-Corp debts (about 10 years because of judgments?) Would he then be able to have the S-Corp earn income up to the disallowed/suspended loss amount without paying income tax on the pass-through income? If this works, retained profits and distributions he might make in the future might not be income taxed.

Of the $300,000 in liabilities of the S-Corp, about $50,000 of that is from tax liabilities including penalty and interest. Maybe keeping the S-Corp open would be more trouble with taxing authorities than it's worth.

There may be an issue of cancellation of debt income. If none of the creditors issue a 1099-C, and the statute of limitations runs out, does that need to be reported as cancellation of debt income, even if the creditors never indicate to him that the debt is considered cancelled?

[veritas]

At risk losses

From Kleinrock's-more information.

f)Cancellation of Indebtedness and Code Section 108: Special Rules for S Corporations

When an S corporation realizes cancellation-of-indebtedness income, the bankruptcy/insolvency exclusion rules of Code Section 108(a) apply at the corporate level. Code Section 108(d)(7)(A). Consequently, the insolvency or bankruptcy of a shareholder of an otherwise solvent S corporation will not permit the corporation to avail itself of the exclusion rules of Code Section 108(a).
The tax-attribute reduction rules of Code Section 108(b) also apply at the corporate level. Code Section 108(d)(6), For purposes of applying the attribute-reduction rule of Code Section 108(b)(2)(A) (regarding net operating loss carryovers), each shareholder's pro-rata share of losses suspended by operation of Code Section 1366 is subject to reduction. Code Section 108(d)(7)(B). If an S corporation realizes cancellation-of-indebtedness income that it excludes from gross income pursuant to Code Section 108(a), a shareholder's basis in stock is not increased by his pro-rata share of the excluded


This did not answer you question in this thread but it gives a more definitive answer to what happens to the losses.

[veritas]

Here's some more info

Originally, the Supreme Court held that an S shareholder could increase its S stock basis for discharge of indebtedness income excluded from a bankrupt or insolvent S corporation's income. Gitlitz v. Commissioner, 531 U.S. 206 (2001). However, reacting to this decision, Congress revised the Code to provide that income from the discharge of indebtedness that is excluded from an S corporation's income is not taken into account as an item of income by any shareholder and thus does not increase the basis of any shareholder's stock in the corporation.1 The Code now reflects the IRS's position in Reg. Section 1.1366-1(a)(2)(viii) that discharge of indebtedness income is not tax-exempt income and thus does not increase shareholder basis.

OBSERVATION: Generally, the change to the Code regarding discharge of indebtedness income applies to discharges of debt after October 11, 2001, in taxable years ending after that date. However, it does not apply to any debt discharge before March 1, 2002, under a plan of reorganization filed with a bankruptcy court on or before October 11, 2001.

[veritas]

Since the debt is not

cancelled to the corporation does that mean nothing has happened?

If so your idea to keep the corporation until some gains occur to increase basis and allow the losses to be absorbed might have merit.


I don't know the answer.

To bad O..J... isn't around.

[phoenyx]

Veritas,

Thank you again for very informative posts.

I'm going to have to think through this and work through this in some detail.

The stockholder might have a large amount of cancellation of debt income through the Chapter 7 bankruptcy. It's not considered taxable income since he will be going through bankruptcy (otherwise insolvancy would even get him out of it), but it will still reduce the tax attributes which include net operating loss. A few people have said not to treat something as cancellation of debt if no 1099-C is issued, but I'm not convinced if that's right.

If a taxpayer had a $250,000 net operating loss carryforward, and had about $250,000 discharged in bankruptcy, shouldn't they lose that net operating loss through Form 982 (Reduction of Tax Attributes Due to Discharge of Indebtedness) even if there is not a 1099-C issued? Seems like they should lose if even without a 1099-C, even though I've had a ton of people on several forums say without a 1099-C, not to treat it as cancelled debt.