Bankruptcy-S-CorpTax Matters

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					                             Tax Matters
              From AICPA, Journal of Accountancy, November, 2003

                                    Tax Cases

Bankruptcy and S Corporation Pass-Through

Although there are some signs the economy is improving, many businesses
continue to fail. Recently the Tax Court considered the effect of an S
corporation’s selling an asset while in bankruptcy. All S corporation shareholders
contemplating filing for corporate bankruptcy need to consider the potential tax
outcome of such a move.

Alphonse Mourad was the sole shareholder of V&M Management Inc., an S
corporation. On January 8, 1996, the corporation filed a Chapter 11 bankruptcy
reorganization petition. The court appointed an independent trustee to administer
the reorganization. On September 26, 1997, the court approved the plan. The
trustee sold the corporation’s main asset for $2,872,351, realizing a gain of
$2,088,554. The trustee reported the gain on form 1120S and sent a form K-1 to
the shareholder. Mourad did not report the gain as income and the IRS
determined a deficiency. He later claimed he should not be treated as the
shareholder of an S corporation following V&M’s bankruptcy petition. Mourad
also argued he should not have to report the gain because he did not benefit
from the sale.

Result. For the IRS. The general rule is that following a valid S election,
shareholders must report and pay tax on the corporation’s income. This system
of taxation continues until the S election terminates. A company’s S corporation
status can end in any of three ways:
 Shareholders voluntarily revoke the entity’s S corporation status.
 The corporation has excessive passive income for three consecutive years.
 The corporation ceases to be a small business corporation that is eligible for S

The first two circumstances did not apply to this case. Therefore, the court
addressed whether the corporation had stopped being eligible for S status.

To be eligible for S corporation status, a corporation cannot have

 More than 75 shareholders.
 A shareholder that is other than an individual, estate or qualified trust.
 A nonresident alien shareholder.
 More than one class of stock outstanding.

Filing a bankruptcy petition—as V&M Management did—did not violate any of the
above requirements. Therefore, according to the court, the company’s S election
was not terminated.

As additional support, the court referred to a prior case, In re Stadler Associates
Inc., in which the Florida bankruptcy court held that filing a bankruptcy petition
did not terminate an S election. Although Stadler involved a Chapter 7
bankruptcy and Mourad Chapter 11, the result was the same. The differences
between the two filings were in the remedies the companies sought, not the tax
treatment. The court ruled that V&M’s S corporation status was still in effect and
that Mourad should have included his share of the gain in income.

In rejecting Mourad’s contention that he shouldn’t be taxed on the gain because
he didn’t benefit from the property’s sale, the court noted that the taxpayer
previously had benefited from the single taxation of the company’s income and
the pass-through of losses. Therefore, he now had to pay tax on the pass-
through gain from the sale of the entity’s property, even though the taxation
would be detrimental to him. The result, according to the court, would be

There was one concern the case did not raise, and therefore, the court did not
deal with it. Since the corporation filed a bankruptcy reorganization plan, it likely
was insolvent. In that case it could be argued the creditors were the de facto
shareholders and should have reported the gain. However, it isn’t likely any court
would have accepted this argument and shifted the tax to the creditors. As a
result all S shareholders should be prepared to report and pay tax on any gains
from asset sales during a bankruptcy reorganization.

 Alphonse Mourad v. Commissioner, 121 TC no. 11.

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of
Accounting and director, MTA program, Culverhouse School of Accountancy,
University of Alabama, Tuscaloosa.

Reasonable Compensation
Determining what constitutes reasonable compensation is a long-standing issue
for C corporations. IRC section 162(a)(1) allows a deduction for reasonable
compensation for personal services actually rendered. The IRS views
unreasonable salaries as disguised dividends, making them nondeductible by C
corporations and taxable to the shareholder. This means employee shareholders
are double-taxed on such amounts.

The courts and the IRS consider many factors in determining the reasonableness
of compensation, including an individual’s qualifications, the work involved, the
nature of the business, the relationship between gross and net income, business
conditions, salaries in relation to dividends, comparable salaries in comparable
companies, the salary policy of the company in question, salaries paid in prior
years and pension or profit-sharing plans. They examine all of the facts and
circumstances; no single factor is paramount. A recent Tax Court decision
addressed this issue.

Brewer Quality Homes sells mobile homes and is owned 50/50 by husband and
wife shareholders. After the IRS conceded the wife’s compensation was
reasonable (the initial deficiency notice partially disallowed deductions for both
spouses), the issue before the Tax Court centered on the reasonableness of the
husband’s compensation for 1995 and 1996.

In this case the factors indicating a relatively high level of reasonable
compensation include the husband’s involvement in all aspects of the company
since its inception, the company’s rapid growth, his personal guarantee of the
company’s debt, the fact the company did not furnish that individual with a
defined benefit or profit-sharing plan and the company’s ability to survive several
significant economic downturns in contrast to many of its competitors.

On the other hand the factors indicating a relatively low level of reasonable
compensation include excessively high percentages of compensation to gross
sales and taxable income; the company’s failure to maintain a compensation
policy for the husband (who thus could set his own pay since he controlled the
company); bonuses given to him on an ad hoc basis without any prescribed
formula and many times his regular salary; the company’s omission of dividends
in two recent years even though profits were higher than in two previous
dividend-paying years; and the company’s average return on its equity being
below that of comparable businesses.

The IRS contended that part of the husband’s compensation represented
disguised dividends because

 If the company had a good year, so did the husband.
 The ad hoc bonus and absence of a compensation plan reflected an intent to
pay dividends rather than salary.
 In a C corporation, double taxation of retained earnings and dividends occurs,
giving the company an incentive to pay higher compensation.

To evaluate the reasonableness of compensation, both the company and the IRS
brought in expert witness testimony. The court was not persuaded by much of it.
Nevertheless, in its deliberations the court used some of the data, particularly the
Robert Morris Associates (RMA) statistics concerning executive compensation as
a percentage of sales.

Result. Partially for the IRS. The court concluded that factors taken from the
RMA 90th percentile were appropriate for determining reasonable compensation.
By applying these factors and making other adjustments for nonsalary
considerations, the court arrived at levels of reasonable compensation that
exceeded those of the IRS but were less than the deductions the corporation
took. Thus, the court deemed part of the payments to be noncompensation,
resulting in tax deficiencies for the years in question.

This decision reinforces the need for proper planning to help ensure the
deductibility of executive salaries in a closely held business. It also emphasizes
the need for careful consideration of appropriate entity choice and possible
alternatives to C corporation status.

 Brewer Quality Homes Inc., TC Memo 2003-20, July 10, 2003.

Prepared by William J. Cenker, CPA, PhD, KPMG Professor of Accounting and
Robert Bloom, PhD, professor of accounting, both at the Boler School of
Business, John Carroll University, University Heights, Ohio.

Losses Trust Deducted Were Not From Passive Activity
IRC section 469(a)(1) defines a passive activity as one involving the conduct of
any trade or business in which the taxpayer does not materially participate. In
section 469(a)(2), the statute describes a taxpayer as any
 Individual, estate or trust.
 Closely held C corporation.
 Personal service corporation.

In general, the IRS will treat a taxpayer as materially participating in an activity
only if that taxpayer is involved in the operations on a regular, continuous and
substantial basis.

The Mattie K. Carter Trust was established in 1956 under the will of Mattie K.
Carter. Benjamin Fortson, the trustee since 1984, manages its assets, including
the Carter Ranch, which the trust has operated since 1956. The ranch covers
some 15,000 acres and includes cattle-ranching as well as oil and gas interests.
At the times in question the Carter Trust employed a full-time ranch manager and
other employees who performed essentially all the ranch’s activities. Fortson also
devoted a substantial amount of time and attention to ranch activities.

The Carter Trust claimed deductions for losses it incurred in connection with the
ranch operations for 1994 and 1995 of $856,518 and $796,687, respectively. In
April 1999 the IRS issued a deficiency notice disallowing the deductions because
of section 469’s passive activity rules. The Carter Trust paid the disputed tax in
full plus interest and made a timely refund claim, which the IRS denied. The trust
then sued for a refund in district court.

The court considered the question of whether the Carter Trust materially
participated in the cattle-ranch operations or was otherwise “passively” involved.
The IRS argued a trust’s “material participation” in a trade or business, within the
meaning of section 469(h), should be determined by evaluating only the trustee’s
activities. The IRS proposed to disallow the losses in full for both tax years
because the trustee, Fortson, failed to meet the IRC’s material participation
requirements. The IRS classified the losses as “passive activity losses.”
The Carter Trust said it—not the trustee—was the taxpayer, and material
participation should be determined by assessing the trust’s activities through its
fiduciaries, employees and agents. The trust also said that as a legal entity, it
could participate only through the actions of those individuals. Their collective
efforts on the cattle-ranching operations during 1994 and 1995 were regular,
continuous and substantial.

Result. For the taxpayer. The court found the IRS’s contention that the trust’s
participation in the ranch operations should be measured by referring to the
trustee’s activities had no support within the plain meaning of the statute. The
court said this position was arbitrary and subverted common sense and, in the
absence of case law or regulations, the IRS should not create ambiguity where
there was none.

The court held it undisputed that the Carter Trust, not its trustee, was the
taxpayer. The trust’s participation in the ranch operations entailed an assessment
of the activities of those who labored on the ranch, or otherwise conducted ranch
business on the trust’s behalf. Their collective activities during the times in
question were regular, continuous and substantial enough to constitute material

The court concluded the losses the Carter Trust had sustained were not passive
within the meaning of section 469. The IRS had improperly disallowed the
ranching losses as passive activity losses, and the trust was entitled to a refund
of the overpaid taxes with interest.

 Mattie K. Carter Trust v. United States, 256 F Supp 2d 536 (Tex. 2003).

Prepared by Claire Y. Nash, CPA, PhD, associate professor of accounting,
Christian Brothers University, Memphis, Tennessee, and Tina Quinn, CPA, PhD,
associate professor of accountancy, Arkansas State University, Jonesboro.

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