What Do I Need to Know about S Corporation Bankruptcy?

October 6, 2022

When small business owners form their official entities, they might choose to open what's known as an S corporation. This type of business has either a small partnership or a single proprietor at the top of the ownership ladder.

S corporations are chosen as the type of business for entities that have a limited number of shareholders most of the time, or that are owned and operated by one person. 

If these businesses don't end up producing as expected, or if they run into financial trouble, the ownership group might decide to file for bankruptcy. Understanding what happens in this case, including at the details surrounding it, is very important for all those who own and run an S corporation.

What Happens When an S Corporation Files for Bankruptcy?    

S corporations are treated like other types of corporations when it comes to filing bankruptcy. They are relegated for small businesses, and as such, the income from the business passes onto the owner or owners as well as the shareholders.

If these owners decide to file bankruptcy, a stay is automatically put into place so that creditors are not allowed to collect any money that is owed to them. This will remain in place until the owners have a chance to provide financial information to the court.

The S corporation will have a choice to file either Chapter 7 or Chapter 11 bankruptcy, which will depend on the company's current financial circumstances and whether they're able to continue operating. 

Does S Corp Offer Limited Liability?

Much like LLCs, an S corporation does offer some limited liability to owners and shareholders. The entity is a pass-through taxation, meaning that all income and losses are posted onto the personal tax returns of each of the owners and shareholders.

The formation of the S corp will provide these owners with some limited liability, though an LLC typically provides more protections based on local laws in the state in which the entity was formed.

Are You Personally Liable for an S Corp?    

An S corp protects the personal assets of all shareholders, who are not responsible for the business debts and legal liabilities of the business. Importantly, creditors aren't able to seize the personal assets of shareholders and owners in the case of a bankruptcy.

Does Personal Bankruptcy Affect My S Corp?

The same line of thinking holds true the other way. S corps are completely independent of the owners and shareholders. As such, personal bankruptcy filings have no effect on the S corp.

Who is Responsible for S Corp Taxes?

All tax information for an S corp is passed through to the owners and shareholders of the company. For federal tax purposes, these owners and shareholders will report all income and losses, credits and deductions on their own personal federal tax returns.

S corporations are only responsible for paying tax on some passive income and built-in gains, as set by the Internal Revenue Service.

What Revokes an S Corp Status?

What type of bankruptcy the S corp owners choose will determine whether the corporation is revoked or not. Chapter 11 bankruptcy is often chosen when the owners would like to find a way to become fiscally solvent and then continue to operate the business after.

If this is not in the interest of the owners -- or if it's just not feasible -- then they will likely choose Chapter 7 bankruptcy. In this type of bankruptcy, the business assets will be liquidated, and the proceeds will be used to pay outstanding debts. The bankruptcy court will be the one to determine what debts will be paid.

After this is completed, the business will close and the S corp status will be revoked.

What Happens to Debt When You Dissolve an S Corporation?    

The Chapter 7 bankruptcy process will determine how debts are handled. As mentioned, the bankruptcy court will work to liquidate the assets of the company and then distribute that to the various creditors.

Any debt that isn't able to be repaid will ultimately become discharged -- just as unsecured debts in a personal Chapter 7 bankruptcy are.

Can I Use a Bank Account after Dissolving an S Corporation?

Once an S corporation is dissolved, owners are not able to access bank accounts, or the funds in them, that are owned by the business. The bank accounts will only be used to meet the remaining debts at the bankruptcy court's discretion.

Do I Still Owe Money to a Dissolved Company?

People and entities that owe money to a company that is filing for bankruptcy still must pay their outstanding debt. That debt will be used to help the S corp pay its own outstanding debts through the bankruptcy process.

What are the Treatments for Loans to Shareholders When Dissolving an S Corp?

Loans to shareholders are considered to be assets to the corporation. As such, they must be recovered so creditors are able to be paid through the bankruptcy and so that distributions are properly made.

Can a Dissolved S Corporation Be Sued?

When S corporations are dissolved, they still exist legally. Dissolution is actually only the first step of closing an S corporation. Depending on the state in which the business is formed, there may be other procedural steps to take to fully close it. 

This means that, because the S corporation still legally exists, it can still be sued. However, the same liability limitations still exist as well, meaning owners and shareholders won't lose their legal protections from lawsuits.

What Does it Take to Pierce the Corporate Veil?

Courts will determine whether to pierce the corporate veil and hold individual owners and shareholders responsible for the business' actions and/or liabilities. The court system must determine, in some cases, that the corporation is simply an agent for the owner/shareholder. If it does, it may pierce the corporate veil and then hold any principals liable for the debts and liabilities of the corporation.

The specific guidelines that the courts will follow to make this determination will be based on the state in which the S corporation was formed.

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