IRS Audits for Insolvent Taxpayers

When times are good, we don’t need to worry about the tax loss rules, the net operating loss (“NOL”) rules, or even the bankruptcy tax rules. But these rules are front and center in most tax planning and advice during and after an economic downturn.

We saw this with the 2001 dot com bust, the 2008 mortgage crisis, and, here in Houston, the 2017 storm disaster. We will likely see it again due to the COVID situation.

Given the current economic downturn, the recent In re Ivison, No. 13-37732 (Bankr. S.D. Tex. 2020) provides an opportunity to consider what might be a common fact pattern in the coming months and possibly years. It concerns a taxpayer who agreed to an IRS audit adjustment thinking a tax loss would be allowed to offset the additional tax. Insolvent taxpayers who agree to IRS audit adjustments should pause to consider these rules.

Facts & Procedural History

This case involves a husband and wife who each owned a 50% interest in two S corporations. The husband was paid a salary of $150,000 a year, even though the S corporations were incurring nearly $1 million in losses each year.

The IRS assessed significant tax for the taxpayers in 2011. This tax was due to officer compensation paid to the husband that was not reported for tax purposes. Apparently, the taxpayers had agreed to this adjustment during the course of the IRS audit.

It appears that the taxpayers agreed to this audit adjustment thinking that they had a sufficient amount of tax basis in the S corporation to offset the income with losses from the businesses.

To fend off the IRS, the taxpayers both filed Chapter 7 bankruptcy in late 2013. One of the S corporations also filed Chapter 7 bankruptcy around the same time.

The wife’s bankruptcy resulted in a discharge and was closed in 2014. The husband’s bankruptcy had the same result. But with the husband’s bankruptcy, the IRS filed a $1.5 million unsecured priority claim. The IRS was paid $6,000 for the claim.

The husband and wife reopened their bankruptcy cases in 2015 to redetermine the amount of tax and penalties owed to the IRS (this post does not address the trust fund penalties that were assessed and considered by the bankruptcy court; we are focusing in on the income tax assessment only).

The question for the bankruptcy court was whether the husband and wife were liable for income taxes for 2011.

The Bankruptcy Court’s Power Over Tax Cases

The bankruptcy court is authorized to determine the amount of tax and penalties due. This type of tax litigation is authorized by 11 U.S.C. § 505. This authority is limited to cases that have not been previously litigated in other courts.

Taxpayers can use 11 U.S.C. § 505 to contest the amount of tax and penalties. But the IRS can also use this law. The IRS can use this law to reduce a tax liability to a judgment. It can then collect on the judgment.

That is what happened in this case. The taxpayer brought the suit under 11 U.S.C. § 505 and, as discussed below, the IRS was able to get a judgment from the court for the amount of the liability it says was due and owing.

Flow-Through Losses Limited by Basis

As noted above, the S corporations were incurring nearly $1 million in losses each year. These losses would flow through and be reported on the taxpayer’s individual income tax returns.

There are several rules that can limit flow through losses. Tax basis is one such rule. Generally, losses from S corporations are limited for the shareholder by the amount of the shareholder’s basis in the S corporation stock. This is found in Sec. 1366(d). These losses are suspended and carried forward to the year in which there is a sufficient amount of tax basis to use the losses.

During the bankruptcy trial, the taxpayers testified that they sold the S corporation in 2012 for $800,000 and contributed the funds to the S corporation in 2013. Contributions to S corporations generally do increase the shareholders’ tax basis in the S corporation stock.

But this contribution was not made until 2013. The bankruptcy court concludes that this 2013 contribution would not have helped the taxpayers offset an IRS audit adjustment for the 2011 tax year. The bankruptcy court correctly notes that Sec. 1366(d) bars a loss in excess of the taxpayer’s tax basis in the S corporation shares. The court’s analysis stopped there.

Flow-Through Losses Producing NOLs

Given the facts in the court’s opinion it is hard to tell, but it would seem that the analysis should continue beyond Sec. 1366(d). The Sec. 172 net operating loss (“NOL”) rules would seem to apply.

Given these rules in effect as of the 2013 tax year (prior to the TCJA changes–which have now been largely repealed by the CARES Act), if the taxpayers had an $800,000 basis in the S corporation shares in 2013 and this amount exceeded their income in 2013, they would have triggered a carryback. The loss would carry back to prior tax years and very well may have offset the 2011 IRS audit adjustment. The taxpayers may have been correct in this regard.

If correct, the analysis may need to also consider whether the NOL could be used if it carried back first to a year in which the taxpayer’s liabilities were discharged in bankruptcy. This is a question for another article.

The Takeaway

The NOL rules are complex. The interplay of the NOL rules with other tax laws can lead to a number of difficult questions. The questions can be even more difficult when bankruptcy and the bankruptcy rules apply. This is particularly true as you apply the web of rules to specific fact patterns.

Taxpayers who incur losses should consult with their tax attorneys. This is an area where advance tax planning can result in significant tax savings.

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