Court Allows Adversary Proceeding Against Former S Corp Shareholders To Go Forward

(Parker Tax Publishing June 2022)

A district court denied a motion for interlocutory review of a bankruptcy court's decision to allow an adversary proceeding filed by a bankruptcy trustee against the shareholders of the debtor, a corporation, to go forward after finding that the interlocutory review would produce piecemeal litigation. The court found that the issues involved in the trustee's adversary proceeding, which sought to invalidate tax returns the debtor corporation filed after converting from an S corporation to a C corporation, would be addressed by the bankruptcy court when it ruled on two other pending motions. In re GYPC, Inc., 2022 PTC 155 (S.D. Ohio 2022).

Background

Christopher Cummings and Eric Webb (the shareholders) own 100 percent of GYPC, Inc. GYPC was treated as an S corporation for federal income taxes purposes starting in 2013. In February 2017, GYPC's tax status was converted from an S corporation to a C corporation. In March 2017, GYPC filed for chapter 11 bankruptcy. Despite the change in its tax status, GYPC still filed S corporation federal tax returns for 2017 and 2018. In August 2019, GYPC's case was converted to a chapter 7 bankruptcy. This meant that, rather than reorganizing the company, the result of the bankruptcy would be to sell GYPC's nonexempt assets and distribute the proceeds to its creditors.

A trustee was appointed in September 2019. The trustee did not know it at the time, but in October 2019, GYPC filed amended C corporation tax returns for the post-conversion period in 2017 (February through December 2017) and the complete 2018 tax year (the post-conversion returns). The trustee learned of the conversion when, in September 2020, he filed an S corporation return on behalf of GYPC only to be told by the IRS that GYPC's S election was terminated in February 2017. In response, the trustee filed amended post-conversion returns that shifted deferred income from tax year 2017 back to GYPC's pre-petition 2016 S corporation return. The trustee's amended returns - if accepted by the IRS - would eliminate the bankruptcy estate's tax liability and offload about $4 million in tax liability back to the shareholders.

The trustee argued that the post-conversation returns should be avoided and replaced by its amended S corporation returns and filed an adversary proceeding against the shareholders under 11 U.S.C. Section 549 (Section 549 claim) to avoid the post-conversion returns as an avoidable post-petition transfer of property. The trustee specifically sought (1) a declaration that the filing of post-conversion returns was a transfer of property of the estate that was not authorized by the Bankruptcy Code and a (2) declaration that he (the trustee) was authorized to file a tax return for the 2017 full year and 2018 on behalf of the debtor or, in the alternative, that the amended returns filed by the trustee would be considered the return.

Seizing on the word "declaration," the shareholders filed a motion to dismiss arguing that the Declaratory Judgment Act (DJA) (i.e., 28 U.S.C. Section 2201(a)), deprived the bankruptcy court and the district court of subject matter jurisdiction to hear the trustee's Section 549 claim. The shareholders also contended that dismissal was appropriate because a change in corporate tax does not constitute transferrable "property."

Observation: In a response to the shareholders' motion to dismiss (In re GYPC, Inc., 2022 PTC 156 (Bankr. S.D. Ohio 2022)), the government agreed with the shareholders that the trustee's adversary proceeding should be dismissed, but for different reasons. The government argued that although it was clear the post-conversion returns reported the liabilities of the bankruptcy estate, it was unclear how they affected any assets of the estate. According to the government, its claims were based on the Internal Revenue Code and if the trustee disagreed with the returns he should simply object to the allowance of the request for payment filed by the IRS. The government also said that it was unclear how the filing of the post-conversion returns constituted a transfer, as there did not appear to be a transferor or transferee. Further, the government noted that Code Sec. 1398 sets forth a list of tax attributes that the bankruptcy estate receives from the debtor, including net operating loss carryovers, basis, holding period, method of accounting, etc., and the ability to file a return is not treated as a tax attribute. The only tax attribute at issue in the trustee's adversary proceedings, the government asserted, was GYPC's ability to convert from an S corporation to a C corporation and the bankruptcy estate had no property interest in that conversion.

Bankruptcy Court's Decision

The bankruptcy court denied the shareholders' motion to dismiss. It first determined that the DJA did not bar the trustee's claim. In the bankruptcy court's view, the DJA was inapplicable because the trustee was not seeking a declaratory judgment but rather an order voiding the post-conversion returns. Even if the DJA applied, the bankruptcy court continued, its federal-tax exception did not deprive the court of subject matter jurisdiction. Rather, said the bankruptcy court, the DJA only precludes jurisdiction over "ordinary" federal tax collection matters.

The bankruptcy court then determined that a C corporation's tax attributes fit into the broad definition of estate property and a debtor corporation's tax status has a "significant" effect on the estate's assets. After all, the court said, tax liability can only be satisfied with proceeds from the estate. The bankruptcy court was satisfied that the trustee stated a plausible Section 549 claim and denied the shareholders' motion to dismiss.

The shareholders then asked a district court to conduct an interlocutory review of the bankruptcy court's order. They contended that the bankruptcy court erred in determining that the DJA's federal tax exception did not strip the court of subject matter jurisdiction.

Analysis

The district court concluded that interlocutory review of the bankruptcy court's motion to dismiss order was unwarranted and denied the shareholders' motion for leave to file an interlocutory appeal. The district court explained that interlocutory appeal is appropriate if (1) the appeal involves a controlling question of law, (2) there is a substantial ground for difference of opinion about the answer, and (3) an immediate appeal from the order may materially advance the ultimate termination of the litigation.

The district court found that the shareholders' appeal did not involve a controlling question of law because, even if it reversed the bankruptcy court and the bankruptcy court then dismissed the trustee's complaint, the operative tax return issue would not be put to bed. The court noted that also pending before the bankruptcy court were two other motions concerning the post-conversion returns: one was filed by the government for full payment of administrative expenses (seeking immediate full payment of all taxes, interest, and penalties), and the other was a motion filed by the shareholders to dismiss the trustee's adversary proceeding for failure to join the government as a necessary party. The court noted that the government joined the shareholders' motion to dismiss, arguing (as it did in its earlier response to the shareholders' first motion to dismiss the trustee's adversary proceeding) that the proper vehicle to resolve the operative tax return issue was its motion for administrative expenses. In the government's view, the trustee could contest any alleged tax debt by filing an objection to the government's claim, and the district court said that would force the bankruptcy court to decide whether GYPC had authority to file the post-conversion returns. Thus, it was far from clear to the district court that interlocutory review would resolve the post-conversion return issue, even if the adversary proceeding were dismissed. The court also expressed concern that a piecemeal resolution could create further confusion and unnecessary litigation.

On the issue of whether there was a substantial difference of opinion, the court found that the shareholders' arguments glossed over the threshold question of whether the DJA even applied to the trustees' cause of action, to which the bankruptcy court answered no. In the view of the bankruptcy court the trustee was not seeking a declaratory judgment, so the DJA's federal-tax exception did not deprive the court of subject matter jurisdiction, and the shareholders did not challenge this portion of the bankruptcy court's conclusion. The district court therefore saw no reason to disturb the bankruptcy court's ruling, especially in an interlocutory fashion.

As for whether the appeal would advance the termination of the litigation, the court found that this element overlapped with the "controlling question of law" inquiry. The court said it remained concerned that interlocutory review would not only produce a piecemeal resolution of the operative tax return question but conflict with the bankruptcy court's decision on the government's administrative expenses motion. The court explained that interlocutory review is best exercised when the appellate court can take the case off the lower court's hands and bring about a decisive resolution, and the shareholders failed to show that an interlocutory appeal would accomplish that outcome.

For a discussion of the tax treatment of income, deductions, and credits of a bankruptcy estate, see Parker Tax ¶16,150.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com

We hope you find our professional tax research articles comprehensive and informative. Parker Tax Pro Library gives you unlimited online access all of our past Biweekly Tax Bulletins, 22 volumes of expert analysis, 250 Client Letters, Bob Jennings Practice Aids, time saving election statements and our comprehensive, fully updated primary source library.

Try Our Easy, Powerful Search Engine

A Professional Tax Research Solution that gives you instant access to 22 volumes of expert analysis and 185,000 authoritative source documents. But having access won’t help if you can’t quickly and easily find the materials that answer your questions. That’s where Parker’s search engine – and it’s uncanny knack for finding the right documents – comes into play

Things that take half a dozen steps in other products take two steps in ours. Search results come up instantly and browsing them is a cinch. So is linking from Parker’s analysis to practice aids and cited primary source documents. Parker’s powerful, user-friendly search engine ensures that you quickly find what you need every time you visit Our Tax Research Library.

Dear Tax Professional,

My name is James Levey, and a few years back I founded a company named Kleinrock Publishing. I started Kleinrock out of frustration with the prohibitively high prices and difficult search engines of BNA, CCH, and RIA tax research products ... kind of reminiscent of the situation practitioners face today.

Now that Kleinrock has disappeared into CCH, prices are soaring again and ease-of-use has fallen by the wayside. The needs of smaller firms and sole practitioners are simply not being met.

To address the problem, I’ve partnered with a group of highly talented tax writers to create Parker Tax Publishing ... a company dedicated to the idea that comprehensive, authoritative tax information service can be both easy-to-use and highly affordable.

Our product, the Parker Tax Pro Library, is breathtaking in its scope. Check out the contents listing to the left to get a sense of all the valuable material you'll have access to when you subscribe.

Or better yet, take a minute to sign yourself up for a free trial, so you can experience first-hand just how easy it is to get results with the Pro Library!

Sincerely,

James Levey

Parker Tax Pro Library - An Affordable Professional Tax Research Solution. www.parkertaxpublishing.com