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

[phoenyx]

In Michigan...

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", Tranquility suggested that the IRS agent may be incorrect, and that without somehow restoring basis, the disallowed/suspended losses might just go 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?What is the name of your state?

 

[tranquility]

My answer was long enough in the first thread, so I didn't end with a question I thought of at the time. Where did the money come from? With all these losses I was wondering how the S-corp was operating, but figured it was because the primary stockholder had loaned the money or that the losses were mostly from depreciation. But here I see:

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

I wonder how much of the debt he personally guaranteed. If the loan was taken by the S-corp, but guaranteed by the stockholder, then the amount is at risk. Are you sure there should even be all these suspended losses?

As to the specific questions you ask here, that would take a lot of time to go through everything and think about it. Sorry, during tax season I don't have the time even if I wanted to give it up for free.

 

[phoenyx]

Tranquility,

Thank you very much for your two very informative replies.

The S-Corp's debt is about $250,000 on bank loans and credit cards to the S-Corp, about $20,000 in misc accounts payable, and about $50,000 in tax liability with penalty and interest. All of the bank loans and credit cards were personally guaranteed by the shareholder, it's just some of the smaller accounts payable and the penalty and interest portions on the tax that isn't personally liable by the shareholder.


I'm thinking since it looks like the suspended losses can't be unsuspended, that I need to further examine the "personal guarantees by shareholder at risk" issue that you brought up.

I looked into that issue in January. I was trying to avoid classifying a lot of the losses as suspended in the first place. I asked an IRS agent in the Individual Complex Tax Law Department whether a stockholder's basis was increased from personal guarantees, as long as the lender wasn't a relative or close friend - and that the lender didn't have anything to do with the company's operation.

The IRS agent put me on hold for some time, and later said "the material I am referring to is unfortunately in internal documents, not publications or code sections." She went on to say that a shareholder's guarantee of a third party loan to an S-Corp does not increase their basis, nor constitute a loan to the S-Corp, unless payments are made based on those personal guarantees -- and in that situation, the amount of increased at risk basis is only for the amount of those payments.

Since the stockholder is filing Chapter 7, and hasn't made any payments on the personal guarantees, and won't be, I decided at the time that didn't increase the amount at-risk.

Then again, looking at my notes, this was the same IRS agent that said all the suspended losses would become unsuspended anyway and declared in full on Schedule E, so maybe she's way off base on this.


If it goes this way, I'd have to look at the cancellation of debt income that came out of the Chapter 7 to see if there was any net operating loss left over. Although cancellation of debt isn't considered income if the taxpayer is insolvant or going through bankruptcy, it still does reduce tax attributes which include net operating losses, so there would still be a substantial reduction (if not entirely) in the losses.

 

[tranquility]

Start at Regs. 1.752-1 and 2. Then, re-read the code regarding at risk.

 

[JOhnBoB]

I am facing somewhat the same problem:
Taxpayer is 100% owner of S-Corp, not passive
Taxpayer has $200,000 in suspended losses
S-Corp is in bankruptcy
Taxpayer loaned S-Corp $270,000
Taxpayer is a creditor in the bankruptcy
S-Corp has -0- assets

(1) Can the loans be reclassified as contributions and free up the losses?
Where would this be done? The taxpayers return or the S-corp's return

(2) Can the loans be considered a Business Bad Debt?

(3) Can I file the 2007 return and wait until next year and/or amend the 2007

Thanks,
John