A Majestic Decision: Delaware Bankruptcy Court Holds Debtor’s QSub Tax Status Is Property of the Estate (Part Two)

Contributed by Yvanna Custodio and Max Goodman
In our previous blog entry on Majestic Star Casino, LLC v. Barden Development, Inc. (In re Majestic Star Casino, LLC), we discussed the background of the case and the holding that Majestic Star’s QSub status is property of the debtor’s estate.  Today, we discuss additional arguments unsuccessfully raised by Mr. Barden, Barden Development, and the Internal Revenue Service as to whether Majestic Star’s QSub status was property of the estate, as well as the court’s ruling that the non-debtor parent’s revocation of its own S corporation status was an avoidable “transfer” pursuant to section 549 of the Bankruptcy Code and violated the automatic stay.
To counter the assertion that Majestic Star’s QSub status is property of Majestic Star’s estate, Mr. Barden, Barden Development, and the Internal Revenue Service argued that the debtor could not have a cognizable property interest in such status because it had no separate existence for federal income tax purposes.  They further argued that Majestic Star’s QSub status was property of Barden Development (Majestic Star’s parent) because its status was dependent on Barden Development’s qualification as an S corporation and Barden Development’s election to treat Majestic Star as a QSub.  The bankruptcy court, citing to In re Prudential Lines Inc. for the proposition that property interests include rights that may be contingent on a non-debtor’s actions, held that Majestic Star’s QSub status, although dependent on the actions of Barden Development, still constituted property of Majestic Star’s estate.
The non-debtors also tried to distinguish the cases holding that an S corporation has a property interest in its S status by arguing that those cases were based on the rationale that S corporations have the right to elect and revoke their S status and that, in contrast, a QSub has no such right.  The bankruptcy court, in addressing this argument, first noted that, contrary to this assertion, an S corporation alone cannot elect S status as a tax law matter – such election requires the consent of all of the shareholders at the time of such election.  Moreover, the court made the practical point that, in reality, the S corporation’s shareholders control both the S corporation and QSub elections – that the S corporation nominally makes these elections is a mere technicality.  Mr. Barden, as sole shareholder of Barden Development, ultimately decided whether Majestic Star should continue as a QSub and whether Barden Development should continue as an S corporation.  The court then observed that the cited decisions also considered the benefit that the S status accords the estate.  According to the court, “[this benefit] includes minimizing tax liability and avoiding the shifting of a tax burden from the principal shareholder back onto the estate and the estate’s creditors.”  As noted in Part One of our blog entry, Majestic Star’s QSub status allowed income and losses to flow through to Barden Development and then to Mr. Barden; as a result, Majestic Star was not liable for taxes on any of its net income.  The court thus concluded that this benefit applies equally to QSubs as it does to S corporations.
The bankruptcy court also concluded that Barden Development’s revocation of its own S corporation status, which automatically terminated Majestic Star’s QSub status, was an avoidable transfer pursuant to section 549 of the Bankruptcy Code.  Section 549 allows the trustee to avoid postpetition transfers of property of the estate that are not authorized by the bankruptcy court or the Bankruptcy Code.  The bankruptcy court cited prior cases that held that, “because the revocation of a debtor’s status as an ‘S’ corporation is an irrevocable election under the [Internal Revenue Code], the revocation is a transfer of the debtor’s property under the Bankruptcy Code.”  Similarly, Barden Development’s revocation of its S status irrevocably terminated Majestic Star’s QSub status.  The bankruptcy court then observed that (i) it was undisputed that both the revocation and the transfer occurred postpetition, and (ii) Barden Development and Mr. Barden admitted the revocation was done without the court’s permission.
Finally, the court held that Barden Development’s revocation of its own S corporation status, which automatically terminated Majestic Star’s QSub status, violated the automatic stay because the revocation “was an exercise of control over the [d]ebtors’ property in violation of [section] 362.”
In re Majestic Star decided a novel issue regarding whether a debtor-subsidiary’s beneficial tax status as a particular kind of flow-through entity constitutes property of that debtor’s estate.  The court’s reasoning in this case as applied to a QSub arguably could apply to any other kind of flow-through entity under applicable tax law, including partnerships, disregarded entities under the so-called “check-the-box” rules (like single member LLCs), qualified REIT subsidiaries, and statutory trusts treated as “grantor trusts.”  A more detailed discussion of tax attributes as property of a debtor’s estate may be found in Section 1002.4 of Henderson & Goldring, Tax Planning for Troubled Corporations: Bankruptcy and Nonbankruptcy Restructurings (CCH 2012 ed.).