An S corporation is a business corporation that elects to be taxed under the sub- chapter S of Chapter 1 of the Internal Revenue Code. The sole purpose for making a business an S corporation is strictly for federal income tax purposes. In general, S corporations do not pay any federal income taxes. Instead, the corporation’s income or losses are divided among and passed through to its shareholders. The shareholders must report the income or loss on their own individual income tax returns.
An S corporation is treated no differently when it comes to eligibility in filing for bankruptcy protection. Even though it is a corporation bankruptcy, an eligibility test is conducted for the S corporation filing just like other bankruptcy filings. The only difference for the S corporation filing comes in the type of bankruptcy you can file. You can file a Chapter 7 or Chapter 11, but you cannot file a Chapter 13 because it is a corporation.
The purpose for filing a Chapter 7 bankruptcy is for liquidating non-exempt assets to pay off unsecured creditors. S corporation assets can be liquidated to pay off creditors, but the process can become convoluted because each shareholder can be held responsible for what passes through the business as income and liabilities.
A debtor can file a Chapter 11 reorganization plan for an S corporation if the needs fit the eligibility of the business. Depending on the financial conditions, what legal actions have occurred and other considerations, the bankruptcy court can potentially force the actions needed to accommodate the conditions.
Unlike other entities, S corporations and its shareholders are not subject to double taxation. Therefore, proceeds of the sale of assets do not get taxed by the IRS like other corporations. That means there are certain tax effects that apply to the shareholders. A bankruptcy by an S corporation has the disadvantage of making the shareholders liable for any income that is taxable and generated after the bankruptcy is filed. The S corporation is not a taxable body.
Because the S corporation has the unique ability to avoid double taxation, the S corporation is limited on the amount of inactive income it can gain. Nevertheless, the shareholder is not removed from the effects of bankruptcy.
There are certain unique relationships within an S corporation that can have an affect on bankruptcy filings. For instance, in an S corporation, your personal liability towards a creditor is not valid if you have not signed a personal guarantee as a shareholder. This type of knowledge is important in understanding the business relationships that can influence how bankruptcy laws are applied if an S corporation is involved.
Because there are unique legal circumstances that can occur in bankruptcy law, it makes good sense to consult with a bankruptcy attorney before you avail yourself before a bankruptcy court, especially if you are entangled with an S corporation.
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