Timing Mistakes That Cost Thousands of Dollars

-   Sometimes we need to talk here about costly taxpayer mistakes that could have been avoided with professional consultation. Take the recent case of a securities firm owner doing business as an S corporation. An S corporation's income is directly taxable to its owners, and its losses pass through to owners for deduction on their tax returns. S corporations are like partnerships in this respect, and the problem we'll describe arises with partnerships, too.

In the recent case, the S corporation had heavy losses during the year. Its owner filed for bankruptcy on December 3, 29 days too soon.

What do we mean "too soon"? When someone files a bankruptcy petition, their assets, with a few exemptions and exclusions, pass immediately to the bankruptcy "estate," to be used to pay creditors who are, for the most part, unsecured. In this case, the owner's S corporation stock was such an asset passing to the estate. With it went an asset (the law calls it a "tax attribute") of great value: the year's tax-deductible loss.

In the owner's hands, the loss would have been enough to eliminate current tax and generate a big net operating loss. Such a loss can be carried to other years, eliminating or reducing tax in those years.

But the owner didn't own the loss. An S corporation's loss for a year is determined when the year ends. At this year's end, the S corporation stock was owned by the bankruptcy estate. By filing for bankruptcy before the end of the year, the owner gave the bankruptcy estate the loss.

The estate acquired the right to carry the year's loss to other years, including back to a prior year when the owner had profits. With this right, the estate could obtain a refund for the taxes the owner had paid in a previous year, even if the owner had made no claim - and didn't know such a claim existed. Alternatively, the estate can carry the loss to future years to offset income arising during bankruptcy from the owner's assets now held by the estate.

The owner argued that since he had held the stock 11/12ths of the year, he should be entitled to 11/12ths of the year's loss. This is not a bad argument, since the law prorates an S corporation stockholder's share of the corporation's loss on a daily basis throughout the year. But the tax rules for bankruptcy trump those for prorating the loss. When the estate took ownership of the stock on December 3, it received all the rights attached to that stock, including the right to claim all the loss determined at year-end.

Note: The court acknowledged that the owner had made an honest mistake, so no penalties were imposed. That must have been some relief. Still, the mistake squandered tens of thousands of tax dollars.

Tip: Here are two ways the owner could have salvaged the loss and its tax value:

1. Wait until the new year, say January 2, to file for bankruptcy.
2. Sell the S corporation stock, if possible, before the bankruptcy filing. This way the owner could get his share of the year's loss (once determined), prorated for the period he owned the stock - here, about 11/12ths of the year's loss.

Note: The transfer of a debtor's assets to a bankruptcy estate is tax-free and not a sale.

The same fate will befall a partner who files for bankruptcy during a partnership's loss year. His or her partnership interest, and that interest's share of partnership loss, will go to the bankruptcy estate. The estate can carry the loss to other years.

Tip for Partners: As with the S corporation stockholder, waiting until year-end before filing will give the partner his or her share of the partnership's loss for the year. Rules for determining share of loss are trickier than with S corporations, where a partner sells his or her interest before the bankruptcy filing - too tricky to summarize here.

If you're at all unclear on how filing a bankruptcy petition could impact your taxes, let us know. We can advise you on the best course of action. Please always feel free to contact us. We are your financial partners, and we are here to help. Give us a call today.

Security Tax Services LLC

North Sound                                       South Sound

2802 Wetmore Ave, Suite 212           33530 1st Way S, Suite 102

Everett, WA 98201                             Federal Way, WA 98003

425.339.2400                                     253.237.0751

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