Field Attorney Advice (FAA) 20253101F, released on August 1, 2025, addresses two critical issues concerning a net operating loss (NOL) carryback claimed by individual taxpayers who are shareholders of an S corporation undergoing Chapter 7 bankruptcy. This memorandum provides valuable insight into the application of S corporation passthrough rules and the implications of corporate bankruptcy on shareholder tax attributes.

Background of the Case

The taxpayers, a married couple filing joint returns, sustained a significant net operating loss (NOL) of approximately $6.9 million in their 2021 taxable year. They filed a Form 1045, Application for Tentative Refund, seeking to carry back this NOL to tax years 2016 through 2020, leveraging the five-year NOL carryback provision of the Coronavirus Aid, Relief, and Economic Security (CARES) Act.

The primary source of this loss was identified as FSH S-Corp, an S corporation owned equally by the taxpayers and incorporated in 2015. FSH S-Corp uses a fiscal year ending September 30 as its taxable year. In 2021, FSH S-Corp filed for Chapter 11 bankruptcy, which was subsequently converted to Chapter 7. The Chapter 7 trustee filed a 2021 Form 1120-S for FSH S-Corp, reporting an ordinary business loss of approximately $6.5 million and an I.R.C. § 1231 loss of approximately $400,000, which were intended to flow through to the taxpayers via Schedules K-1.

On their 2021 tax return, the taxpayers claimed deductions for nonpassive losses from FSH S-Corp, contributing to their reported NOL. They requested a refund of income taxes paid for prior years. The Internal Revenue Service (IRS) Exam team requested Area Counsel guidance on two specific issues:

Issues Presented

Double Benefit Concern: Whether the taxpayers would receive a double benefit from the carryback of NOLs in addition to a bankruptcy discharge of the S corporation’s debts.
Bankruptcy Impact on Funds: Whether the ongoing bankruptcy proceeding of the S corporation impacts the release of refund funds to the taxpayers.

Discussion and Analysis

Passthrough Loss Timing and the "Double Benefit" Inquiry

The FAA clarifies that there is no double benefit because the taxpayers erroneously claimed the FSH S-Corp loss on their 2021 Form 1040.

Applicable Law and Authorities:
- Internal Revenue Code (I.R.C.) § 1366(a)(1) establishes that passthrough items, such as income or losses from an S corporation, are taken into account by the shareholder "for the shareholder’s taxable year in which the taxable year of the S corporation ends".
- Treasury Regulation § 1.1366-1(a) reinforces this principle, stating that the shareholder takes these items into account "in determining the shareholder’s taxable income and tax liability for the shareholders’ taxable year with or within which the taxable year of the corporation ends".
- The FAA cites James S. Eustice, et al., Federal Income Taxation of S Corporations § 7.07, 1-2 (2024), which explains that if a shareholder and an S corporation use different taxable years, the shareholder generally reports corporate income or loss on a somewhat deferred basis. While deferral is typically favorable for income, it is unfavorable for losses. For example, if an S corporation uses a fiscal year ending September 30 and its sole shareholder uses a calendar year, a loss incurred by the S corporation evenly throughout its taxable year starting October 1, 2014, would be deductible by the shareholder on their tax return for 2015.
Author’s Reasoning and Application to Facts: FSH S-Corp uses a fiscal tax year ending September 30, while the taxpayers use a calendar year. According to I.R.C. § 1366(a)(1), passthrough items from FSH S-Corp’s fiscal year ending September 30, 2021, would flow through to the taxpayers’ 2021 Form 1040. Similarly, passthrough items from FSH S-Corp’s fiscal year ending September 30, 2022, would flow through to the taxpayers’ 2022 Form 1040.

The FAA determined that on their 2021 Form 1040, the taxpayers erroneously included passthrough losses from FSH S-Corp’s fiscal year ending September 30, 2022. Consequently, these losses may not be added to the taxpayers’ NOL for 2021. This timing mismatch means the claimed NOL for 2021 was overstated, addressing the first part of the "double benefit" inquiry by clarifying the incorrect reporting of the loss.

Impact of Ongoing Bankruptcy on Passthrough Losses and Fund Release

The FAA concludes that the ongoing FSH S-Corp bankruptcy case does not affect the taxpayers’ ability to claim a passthrough NOL from the entity, nor does it prohibit the release of funds to them.

Applicable Law and Authorities:
- Bankruptcy Code § 727(a)(1) expressly states that "[t]he court shall grant the debtor a discharge, unless (1) the debtor is not an individual".
- Case law supports this:
  - National Labor Relations Bd. V. Better Bldg. Supply Corp., 837 F.2d 377, 378 (9th Cir. 1988), holds that "Partnerships and corporations may not discharge their debts in a liquidation proceeding under Chapter 7 of the Code".
  - In re Lang, 398 B.R. 1, 4 (Bankr. N.D. Iowa 2008), emphasizes that corporations cannot receive a discharge under Chapter 7, as the purpose of a corporate Chapter 7 case is liquidation, not discharge.
- Regarding property of the bankruptcy estate, the FAA references:
  - Segal v. Rochelle, 382 U.S. 375 (1966), which determined that NOLs leading to tax refunds for individual S-corporation owners (who had also filed bankruptcy petitions) constituted property of their individual bankruptcy estates.
  - In re Majestic Star Casino, LLC, 716 F.3d 736 (3d Cir. 2013), citing In re Forman Enters, Inc., 281 B.R. 600, 612 (Bankr. W.D. Pa. 2002), recognized that "when an S-corp files for bankruptcy, its estate cannot contain any NOLs because ’[u]nder the provisions of the [I.R.C.] . . . , the NOL and the right to use it automatically passed through by operation of law to [the] . . . S corporation shareholders".
- The FAA also cites Mourad v. Commissioner, 121 T.C. 1 (2003), which held that an S corporation’s bankruptcy petition does not terminate its status as an S corporation.
Author’s Reasoning and Application to Facts: FSH S-Corp, as a non-individual debtor, is not entitled to a Chapter 7 bankruptcy discharge. Additionally, the individual taxpayers have not filed for bankruptcy, meaning they are also not subject to a bankruptcy discharge of debts.

Crucially, the FSH S-Corp losses do not constitute property of the bankruptcy estate. Under I.R.C. §§ 1363 and 1366, S corporations are generally not subject to federal income taxation, and their losses flow directly through to their shareholders. As shareholders of FSH S-Corp, the taxpayers, not the S corporation itself, have the right to receive the tax benefits for the losses sustained by the entity. Therefore, the NOLs, as they are taken into account in the taxpayers’ NOL for 2021, and any resulting federal income tax refunds, are the property and rights of the individual taxpayers under federal tax law and do not belong to the FSH S-Corp bankruptcy estate under Bankruptcy Code § 541.

Given that FSH S-Corp will not receive a discharge in its Chapter 7 proceeding, and the S corporation’s losses are not property of its bankruptcy estate, Counsel concluded there are no concerns regarding any potential "double benefit" to the taxpayers or FSH S-Corp stemming from the bankruptcy case.

Conclusion and Recommendations The FAA concludes with clear recommendations based on the analysis:

Counsel recommends that the FSH S-Corp passthrough loss from the fiscal year ending September 30, 2022, be disregarded for purposes of the taxpayers’ Form 1040 for the 2021 tax year.
Any NOL carryback from 2021 to 2016 and subsequent years should omit losses attributable to FSH S-Corp’s fiscal tax year ending September 30, 2022.
While the FSH S-Corp bankruptcy proceedings do not affect the release of a requested refund to the taxpayers, the correct application of I.R.C. § 1366(a)(1) does impact their refund request. The taxpayers cannot claim the passthrough loss from FSH S-Corp’s fiscal year ending September 30, 2022, on their 2021 Form 1040, and therefore cannot carry back that specific NOL passthrough amount to their 2016 taxable year.
The memorandum also advises that additional review may be necessary if losses flow through to the taxpayers from other debtor-entities jointly administered under the same lead bankruptcy case, to confirm that their bankruptcy cases do not affect the NOL amount. However, for correctly timed FSH S-Corp losses, the bankruptcy will not prohibit the release of funds to the taxpayers.

Prepared with assistance from NotebookLM.