You can change the corporate structure of your company
Much has been written about the advantages of forming Limited Liability Companies (LLCs) since the new check-the-box regulations were enacted. However, there is one situation in which the right choice of an entity might be a Subchapter “S” Corporation. That situation could be when the taxpayer’s liabilities exceed the fair market value of his or her assets.
Our office receives many calls regarding what the right choice for operating a business should be. Recently, an executive director of an association contacted our office in an effort to determine how many of his members could be Subchapter “S” Corporations. A client also called and asked whether he should change the corporate structure he was presently in, a C Corporation. He stated, “My accountant said I should be a Subchapter “S” Corporation. Should I change my corporate structure?” His accountant may be right.
You may be pleasantly surprised by what is happening in the tax law and courts regarding the Subchapter “S” structure. A new court case involving a privately held company provides an additional reason to consider Subchapter “S” Corporation status for business. Remember, you can change the corporate structure of your company.
Cancellation of Debt
Generally, the rule in the Internal Revenue Code (Code) is that when a debt is cancelled, it is considered income to the debtor and is taxable. However, one of the exceptions to this general rule occurs when a taxpayer is still insolvent after realizing a discharge of indebtedness. A taxpayer is insolvent when the taxpayer’s liabilities exceed the fair market value of the taxpayer’s assets. If the taxpayer is still insolvent after the cancellation of a debt, the entire discharged amount is excluded from his gross income. This is a very important rule. If you are in business and are insolvent and have a creditor cancel a debt, which makes you solvent, you must report income; but if you are still insolvent after the cancellation, you don’t have to report any income.
When a discharge of debt is excluded from gross income, the cancellation must be used to reduce certain tax attributes which, in essence, really defers the “income” rather than exempting it from income all together. The cancellation of a debt is used to reduce (on a dollar-for-dollar basis) any net operating losses, including carryovers from previous years, any general business credits, any capital loss carryovers, any passive activity items or the basis in the taxpayer’s property. However, these rules do not apply to business indebtedness related to any real estate. What does all this mean when choosing a business entity?
Subchapter “S” Pass-Through Tax Characteristics
The basic reason why privately held companies elect Subchapter “S” status is because the Internal Revenue Code allows Subchapter “S” qualified corporation shareholders to elect “pass-through” taxation so that income is subjected to only one level of taxation. Thus, the purpose of the Subchapter “S” Corporation section is to tax income at the shareholder level, not the corporate level. While income is determined at the corporation level, it is done so only to “pass-through” to the “S” Corporation’s shareholders the corporation’s income. The profits pass-through on a pro rata basis directly to the shareholders and are reported on the shareholders’ individual tax returns.
Shareholders of Subchapter “S” Corporations are permitted to increase their corporate basis by “items of income” that are identified in the tax code. These items include tax-exempt income, losses and deductions. This prevents double taxation. A shareholder’s basis in “S” Corporation stock is decreased when losses and deductions are “passed-through.” However, the shareholder cannot take corporate losses and deductions on his personal tax return when those items exceed the shareholder’s basis in the stock and his share of the “S” Corporation’s debt. The amount of those items exceeding the shareholder’s basis are “suspended” until the shareholder’s basis increases enough to allow the deduction.
For example: Assume that Goodpayer owns 50 percent of an “S” Corporation and, for simplicity, the basis of Goodpayer’s shares are $10,000. During the current year, the “S” Corporation has losses totaling $40,000. Goodpayer’s pro rata share of the losses is $20,000. However, since Goodpayer’s basis in the “S” Corporation is only $10,000, only $10,000 of losses can be deducted on Goodpayer’s personal return. The remaining $10,000 is “suspended” until basis is increased by another $10,000. Also, Goodpayer’s basis in the “S” Corporation is now reduced to zero.
Assume the following year that the “S” Corporation is insolvent and has an outstanding debt of $50,000 that is forgiven. This “item of income,” which is normally considered income, is non-taxable since the “S” Corporation is insolvent. In addition, Goodpayer’s pro rata share, $25,000, passes-through to increase Goodpayer’s basis to $25,000, which then allows Goodpayer to deduct losses up to $25,000 on Goodpayer’s personal return.
Reading the above would lead you to conclude that an “S” Corporation taxpayer would be able to get a double windfall. Simply stated, the forgiveness of debt is income that would be excluded from gross income if the taxpayer was insolvent. The shareholders could “pass-through” this “item of income” to increase their corporate basis. The taxpayer could then deduct any losses that were previously suspended because there had not been sufficient corporate basis to deduct the losses. Is this true? Even though the IRS said no, recently the Supreme Court said “Yes.” 1
The Gitlitz Case
In a recent Supreme Court case, referred to as Gitlitz, the taxpayers were each 50 percent owners of P.D.W.& A., a corporation that had elected to be taxed under Subchapter “S” of the Code. In 1991, the corporation realized a $2,021,296 forgiveness of debt. At the time of the forgiveness, the corporation was insolvent in the amount of $2,181,748. The corporation excluded the entire amount from gross income because it was insolvent even after the forgiveness of debt was added to its balance sheet. The owners then increased their basis in P.D.W.& A. stock by their pro rata share (50 percent each) of the amount of the corporation’s forgiveness of debt.
By increasing their basis by $1,010,648 each, the owners were each able to deduct the full amount of their pro rata share of the corporation’s losses on their personal tax returns. The theory was that the forgiveness of the debt was an “item of income” subject to pass-through under the tax code. The owners used their increased basis to deduct corporate losses and deductions, including losses and deductions from previous years that had been carried forward. After the IRS argued that the taxpayers could not use the corporation’s forgiveness of debt to increase their basis in the stock and could not claim the loss deductions, the taxpayers petitioned the Tax Court to review the IRS determinations.
The Tax Court initially granted the taxpayers relief but then sided with the IRS’s Motion for Reconsideration. The Court of Appeals affirmed the Tax Court, then the Supreme Court granted a review to resolve a disagreement between the appellate courts on how to treat a debt cancellation of an insolvent “S” Corporation.
The Supreme Court reversed the lower courts and held in favor of the taxpayers. First, the Supreme Court held that the plain language of the statute states that a cancellation of debt ceases only to be included in gross income if the company is insolvent. Also, even though it is not includible in gross income, the cancellation is still an item of income under the tax law.
Second, the court held that a pass-through to the individual shareholder’s personal tax return occurs before any reduction of tax attributes can occur. The Supreme Court reasoned that this tax code section addresses the question by directing that the cancellation of debt allows the shareholder to adjust his basis in “S” Corporation stock and pass-through all items of income and loss, including adjusting the basis of stock held by each shareholder.
What good news! The special rules for treatment of pass-through items for Subchapter “S” Corporations, coupled with the Supreme Court’s ruling in Gitlitz, have created another reason to select Subchapter “S” status of operation for a privately held company. Until Congress chooses to take some type of action and change the statutes, this incentive provides a significant tax savings to all stockholders of Subchapter “S” Corporations. Any business (except Real Estate) whose liabilities exceed assets, any business with a heavy debt load, or any business facing the prospect of a cancellation of debt should immediately explore this concept and elect to be treated as a Subchapter “S” Corporation.
We called the client back and told him to talk to his accountant, because his accountant may be correct. We also informed the association director that less than 50 percent of his members are Subchapter “S” corporations. Perhaps some good advice for this association would be to inform its members to consider Subchapter “S” status.
1 D.A. Gitlitz, 531 U.S. 206; 121 S. Ct. 701; 148 L. Ed. 2d 613; 2001 U.S. LEXIS 638; 69 U.S.L.W. 4060; 2001-1 U.S. Tax Cas. (CCH) P50,147; 87 A.F.T.R.2d (RIA) 417; 2001 Cal. Daily Op. Service 261; 2001 Daily Journal DAR 259; 2001 Colo. J. C.A.R. 372; 14 Fla. L. Weekly Fed. S 56.
|Meet the Author
Bart A. Basi is a CPA and attorney at The Center for Financial, Legal & Tax Planning, Inc. in Marion, Illinois.