Debtor's QSub Status Is Not Property; Sole Shareholder Entitled to Revoke S Status (Parker's Federal Tax Bulletin: June 05, 2013)

Late last month, the Third Circuit was asked to decide for the first time whether or not the sole shareholder of an S corporation was entitled to revoke an S corporation election with the result being that the S corporation's QSub, which was in a Chapter 11 bankruptcy, lost its QSub election. In reaching its holding in In re Majestic Star Casino, LLC, 2013 PTC 109 (3d Cir. 5/21/13), the Third Circuit rejected conclusions reached by several lower courts that S corporation status was property and vacated a bankruptcy court order compelling the parent corporation to rescind its S revocation. The case reinforces the rule that filing a bankruptcy petition is not supposed to expand or change a debtor's interest in an asset; it merely changes the party who holds that interest. Had the Third Circuit affirmed the bankruptcy court's holding, a QSub in bankruptcy could stymie legitimate transactions of its parent as unauthorized property transfers, even though the QSub would have had no right to interfere with any of those transactions before filing for bankruptcy.

Background

Don Barden was the sole shareholder of Barden Development, Inc. (BDI). BDI elected to be taxed as an S corporation. As a result, BDI's income and losses were passed through to Don, who was required to report them on his tax return.

Majestic Star Casino II, Inc. (MSC II) is a corporation that owns and operates the Majestic Star II Casino and the Majestic Star Hotel in Gary, Indiana. MSC II generates income from those operations. BDI acquired MSC II in 2005 and was, at all times during the years at issue, the ultimate owner of 100 percent of its stock. BDI elected to treat MSC II as a qualified subchapter S subsidiary (QSub) for tax purposes.

In November 2009, the MSC II filed for bankruptcy under Chapter 11 of the Bankruptcy Code. After the bankruptcy filing, Barden, as sole shareholder of BDI, successfully petitioned the IRS to revoke BDI's S corporation status. The revocation was retroactively effective to January 1, 2010, the first day of BDI's tax year. As a result, MSC II's QSub status was automatically terminated as of the end of the prior tax year, because it no longer met the requirement that it be wholly owned by an S corporation. Thus, both BDI and MSC II became C corporations as of January 1, 2010. As a consequence of becoming a C corporation, MSC II became responsible for filing its own tax returns and paying income taxes on its holdings and operations.

MSC II was by then effectively controlled by its creditors, who were not happy with shouldering a new tax burden. MSC II filed an adversary complaint in bankruptcy court asserting that the revocation of BDI's S corporation status caused an unlawful post-petition transfer of property of the MSC II bankruptcy estate.

MSC II's Arguments

MSC II sought relief under Sections 549, 550, and 362 of the Bankruptcy Code. Section 549 provides that a debtor-in-possession or trustee may avoid a transfer of property of the estate that occurs after the beginning of the case and that is not authorized by the court. Section 550 permits the debtor-in-possession or trustee to recover, for the benefit of the estate, property whose transfer has been avoided under Section 549. Section 362 provides for an automatic stay such that the filing of a Chapter 11 petition operates as a stay, applicable to all entities, of any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate. Section 362 also provides that an individual injured by any willful violation of the stay can recover actual damages, including costs and attorneys fees, and, in appropriate circumstances, punitive damages. Section 362 operates differently than Sections 549 and 550, as those latter sections authorize the bankruptcy court to avoid the violative transfer, but the debtor-in-possession or trustee must begin an adversary proceeding. By contrast, under Section 362, a transfer that violates the automatic stay is generally considered to be void without any action on the part of the debtor.

Bankruptcy Court Decision

The bankruptcy court held that because the debtor-corporation's subchapter S status provided the debtor-corporation the ability to pass-through capital gains tax liabilities to its principals, the right to make or revoke its subchapter S status had value to the debtor and constituted property or an interest of the debtor in property. The bankruptcy court reasoned that QSub status is analogous to S corporation status and, based on a few cases holding that the latter is property for purposes of the Code, concluded that the former is property, too.

The principal case relied on by the bankruptcy court was In re Trans-Lines West, Inc., 203 B.R. 653 (Bankr. E.D. Tenn. 1996), which involved the issue of whether a corporation's revocation of its S corporation status before filing for bankruptcy was a prepetition transfer of property avoidable by the trustee under Bankruptcy Code Section 548. The bankruptcy court in that case acknowledged that, in the absence of controlling federal law, the question of whether a debtor possesses an interest in property is governed by state law. However, the court reasoned that, because the subject of the alleged transfer was the debtor's status as a Subchapter S corporation, a status created under title 26 of the United States Code, federal law, and more specifically the Internal Revenue Code, determined whether a debtor held a property interest in its S corporation status. The court observed that property refers to the right and interest or domination rightfully obtained over an object, with the unrestricted right to its use, enjoyment, and disposition. The court in Trans-Lines West, Inc. then concluded that once a corporation elects to be treated as an S corporation, Code Sec. 1362(c) guarantees and protects the corporation's right to use and enjoy that status until it is terminated under Code Sec. 1362(d). According to the court, Code Sec. 1362(d)(1)(A) guarantees and protects an S corporation's right to dispose of that status at will. The court also noted that Code Sec. 1362(c) provides that an S corporation election is effective for all succeeding tax years of the corporation, until the election is terminated, and it reasoned that the Internal Revenue Code thus affords a corporation which has elected the Subchapter S status a guaranteed, indefinite right to use, enjoy, and dispose of that status. From that, the court concluded that the Debtor possessed a property interest (i.e., a guaranteed right to use, enjoy and dispose of that interest) in its Subchapter S status.

As a result of the decision in In re Trans-Lines West, Inc,, the bankruptcy court in In re Majestic Star Casino ordered Barden, BDI, and the IRS to reinstate both BDI's status as an S corporation and MSC II's status as a QSub. Barden and BDI appealed to the Third Circuit.

Barden, BDI, and IRS Arguments

Before the Third Circuit, Barden and BDI argued that the bankruptcy court erred in its holding because the court applied a general overarching bankruptcy principle that anything that brings value into a bankruptcy estate must be a property right, despite the fact that the Bankruptcy Code by itself does not constitute a source of property rights. Likewise, the IRS asserted that simply because an S corporation election means that the corporation may use and enjoy the benefits of a pass-through entity tax status, it does not follow that the post-petition revocation of that election is a transfer of estate property.

Third Circuit's Decision

The Third Circuit began its analysis by noting that the issue in this case, whether a court could order a corporation's shareholder to reinstate an S corporation election, was one that had never been addressed in any appellate court.

As an initial matter, the court rejected Barden's and BDI's argument that the bankruptcy court lacked jurisdiction to order the IRS to reinstate BDI's status as an S corporation and MSC II's status as a QSub. According to the Third Circuit, the bankruptcy court's ability to exercise jurisdiction over the IRS has been affirmed in a number of contexts.

As a threshold matter, the Third Circuit had to decide whether MSC II had standing to challenge the revocation of its QSub status. That, however, required the court to first address the merits of whether the MSC II bankruptcy estate had a property interest in MSC II's QSub status such that the MSC II had the right to challenge what it characterized as the post-petition transfer of that interest.

The Third Circuit looked at the Bankruptcy Code provisions that MSC II and its creditors were relying on. The court noted that all three sections being relied on had three elements in common for purposes of the problem before the court. For the revocation of the S election to be void under Section 362 or avoidable under Sections 549 and 550, the court said, QSub status must be (1) property (2) of the bankruptcy estate (3) that has been transferred. Though a lack of any one of those elements is dispositive, the court chose to consider in the alternative only the first two.

The court noted that the filing for bankruptcy does not create new property rights or value where there previously were none and, consequently, the estate is determined at the time of the initial filing of the bankruptcy petition. Citing the Supreme Court's decision in Butner v. U.S., 440 U.S. 48 (1979), the court noted that the determination of property rights in the assets of a bankrupt's estate is generally determined under state law. However, if some federal interest requires a different result, then property interests may be defined by federal law.

The Third Circuit looked at the cases saying that the ability to make an S corporation election, like the ability to elect whether to carry forward or carry back NOLs, is property. The court found that extension untenable, though, for several reasons. First in applying the NOL-as-property principle, the decision in In re Trans-Lines West, Inc., 203 B.R. 653 (Bankr. E.D. Tenn. 1996) and the other S corporation-as-property cases failed to consider important differences between the two putative property interests. In all events, a debtor in possession of NOLs has a defined amount of them at the time of the bankruptcy filing; they are a function of the debtor's operations before bankruptcy and are not subject either to revocation by the shareholders or termination by the IRS.

By contrast, the court observed, the shareholders of an S corporation can terminate its pass-through status at will, regardless of how long it has been an S corporation and whatever its pre-bankruptcy operating history has been. The tax status of the entity is entirely contingent on the will of the shareholders.

NOLs also have value in a way that S corporation status does not. The value of an NOL is readily determinable as a tax refund immediately available to the bankruptcy estate to the extent it is applied to prior years' earnings, and it is still subject to relatively clear estimation if the debtor decides to carry it forward against future earnings. The value of the S corporation election, however, is dependent on its not being revoked, as well as the amount and timing of future earnings. Moreover, NOL carryforwards may be monetized in a manner that continuing S corporation status cannot. A corporation that does not expect to generate sufficient future earnings to use its NOLs may be purchased by another more profitable corporation, which may then use the NOLs to shelter its own income. By contrast, the sale of an S corporation, the court noted, will generally result in the termination of its tax-free status.

A further flaw in the S-corporation-as-property cases, the court said, is that they presume that once a corporation elects to be treated as an S corporation, the Code guarantees and protects the corporation's right to use and enjoy that status and guarantees and protects an S corporation's right to dispose of that status at will. However, that is not the case as shareholders can elect to revoke the election or other situations may result in the election being revoked.

The Third Circuit also noted that substantial inequities could result if a bankruptcy trustee is permitted to avoid the termination of a debtor's S corporation or QSub status. In such situations, any income generated during or as part of the reorganization process (such as from the sale of assets) is likely to remain in the corporation, and ultimately in the hands of creditors, but the resulting tax liability must be borne by the S corporation shareholders.

As a result, the Third Circuit declined to follow the rationale of In re Trans-Lines West, Inc., 203 B.R. 653 (Bankr. E.D. Tenn. 1996) and its progeny, and concluded that S corporation status is not property within the meaning of the Code.

The Third Circuit then looked at whether MSC II's QSub status was property. As with S corporation status, the court said, the Code does not (and cannot) guarantee a QSub the unrestricted right to the use, enjoyment, and disposition of that status because it depends on a variety of factors that are entirely outside the QSub's control. The QSub has an even weaker claim to the control of its status than does an S corporation, the court said. The use and enjoyment of its entity tax status is not only dependent on its S corporation parent's continuing to own 100 percent of its stock but also on the parent's decision to not revoke the QSub election as well as the parent's continuing status as an S corporation. Nor can the QSub transfer or otherwise dispose of its QSub status. The Third Circuit held that MSC II's QSub status was not property and that the bankruptcy court's contrary conclusion was error.

Finally, the court looked at whether MSC II's QSub status was property of the estate. According to the court, even if QSub status were property, it would still have to be property of the estate for a transfer of that status to be void under Bankruptcy Code Section 362 or avoidable under Section 549. The court said that allowing QSub status to be treated as the property of the debtor subsidiary rather than the non-debtor parent, as the bankruptcy court did, places remarkable restrictions on the rights of the parent, restrictions that have no foundation in either the Internal Revenue Code or the Bankrupcy Code.

First, the corporate parent loses not only the statutory right to terminate its subsidiary's QSub election, but also its right to terminate its own S corporation election. Second, the corporate parent loses the ability to sell the subsidiary's shares to any purchaser other than an S corporation, and would then be required to sell 100 percent of the shares, because any other sale would trigger the loss of the subsidiary's QSub status. Third, the S corporation parent and its shareholders lose the ability to sell the parent to a C corporation, partnership, or other non-S corporation entity, to a non-resident alien, or to more than 100 shareholders, because any of those transactions would also trigger the loss of the subsidiary's QSub status.

The court noted that filing a bankruptcy petition is not supposed to expand or change a debtor's interest in an asset; it merely changes the party who holds that interest. But under the bankruptcy court's holding, the Third Circuit noted, a QSub in bankruptcy can stymie legitimate transactions of its parent as unauthorized transfers of property of the estate, even though the QSub would have had no right to interfere with any of those transactions before filing for bankruptcy.

As a result, the Third Circuit concluded that, even if MSC II's QSub status were property, it is not properly seen as property of MSC II's bankruptcy estate, and the bankruptcy court's contrary holding was vacated.

Staff Editor Parker Tax Publishing

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