Contributed by Doron P. Kenter.
We previously posted on the decision in Majestic Star Casino, LLC v. Barden Development, Inc. (In re Majestic Star Casino, LLC), in which the United States Bankruptcy Court for the District for Delaware held that debtors have a property interest in their status as a qualified subchapter S subsidiary (“QSub”). In an important turn of events, the Third Circuit has reversed the bankruptcy court, concluding that a debtor’s QSub status is not property of the estate and, accordingly, that a nondebtor parent’s revocation of its “S-corp” status cannot be avoided (or voided) in a bankruptcy proceeding. Because the court also concluded that a debtor’s S-corp status cannot be “property of the estate,” it held that such status is not subject to the attendant protections of the Bankruptcy Code. Our coverage of the bankruptcy court’s decision (with a more extensive discussion of the history of the case) is available here and here.
In brief, one of the debtors (The Majestic Star Casino II, Inc., or “MSC II”) was a wholly-owned subsidiary of nondebtor Barden Development, Inc. Barden Development was organized as an “S corporation,” which had the effect of rendering BDI free from state and federal income taxation. Instead, its income and losses were passed through to its sole shareholder, Don H. Barden, who was taxed accordingly. In turn, Barden Development elected to treat MSC II as a QSub, meaning that MSC II was not taxed separately from Barden Development, but that its assets, liabilities, and income were treated (for federal tax purposes) as the assets, liabilities, and income of Barden Development. Accordingly, Mr. Barden was responsible for all tax liabilities on account of both the nondebtor Barden Development and the debtor MSC II.
After the Majestic debtors commenced their bankruptcy cases, Mr. Barden successfully petitioned the IRS to revoke Barden Development’s S-corp status, thereby shifting the tax burden away from Mr. Barden. In turn, MSC II lost its QSub status because it was no longer a subsidiary of an S-corp. As a result, the tax burden for both Barden Development and MSC II was shifted away from Mr. Barden and onto the entities themselves, which had become “C corporations” for federal income tax purposes.
MSC II then successfully moved the bankruptcy court to avoid the revocation of Barden Development’s S-corp status pursuant to section 549 of the Bankruptcy Code, asserting that the revocation of Barden Development’s S-corp status deprived MSC II of its estate property – namely, its QSub status. The bankruptcy court concluded that the petition to revoke Barden Development’s S-corp status violated the automatic stay because such revocation “was an exercise of control over the [d]ebtors’ property in violation of [section] 362 [of the Bankruptcy Code].”
In a critical reversal, the Third Circuit ruled (on direct appeal) that a debtor’s QSub status is neither “property” nor is it “of the bankruptcy estate” and, therefore, a revocation of such status is not subject to avoidance in bankruptcy. Moreover, the Third Circuit went on to part ways with all other courts to have considered whether a debtor’s own S-corp status is property of the estate, holding that it is not estate property and, accordingly, that the revocation of S-corp status is not subject to avoidance.
In reaching this conclusion, the Third Circuit recognized that even though estate property is construed broadly and is generally defined by state law, it is the Internal Revenue Code, rather than state law, that determines the characterization of tax status as a property interest for the purposes of the Bankruptcy Code. With that in mind, the court parted ways with the line of cases following In re Trans-Lines West, Inc., which held that S-corp status is “property” for purposes of the Bankruptcy Code.
S-Corp Status Is Not Property for Purposes of the Bankruptcy Code
First, the Circuit Court agreed with the underlying premise behind that line of cases – namely, that net operating losses (NOLs) may be property of a debtor’s estate – but disagreed with the extension of that premise to the notion that an S-corp election constitutes estate property because it similarly confers a tax benefit on the debtor. The court drew a clear distinction between NOLs and an entity’s S-corp status, noting that an NOL’s value is “readily determinable” and “immediately available,” and, to the extent that an NOL is carried forward, it is “subject to relatively clear estimation.” S-corp status, on the other hand, is entirely dependent on its not being revoked (which revocation is subject to the will of the shareholders). Moreover, the value of an S-corp election is subject to the amount and timing of future earnings and it cannot be monetized (i.e., sold) in the same way that an NOL might be.
Second, the Circuit Court rejected the suggestion in Trans-Lines West and its progeny that “once a corporation elects to be treated as an S corporation, [the Internal Revenue Code] guarantees and protects the corporation’s right to use and enjoy that status … and [its] right to dispose of that status at will.” Rather, the Circuit Court held that this line of cases reflected “flawed reasoning” and an “incomplete and inaccurate understanding of the law,” and that the Internal Revenue Code does not guarantee a corporation’s right to elect or maintain S-corp status, because such election is, in any event, subject to the S-corp’s shareholders’ sole discretion.
Third, the Circuit Court rejected the suggestion that an S-corp election is “property” because it has value to the estate – instead, section 541(a)(1) of the Bankruptcy Code only defines property to include the “legal or equitable interests of the debtor in property as of the commencement of the case.” This definition, according to the court, “does not extend so far as to override rights statutorily granted to shareholders to control the tax status of the entity they own.”
Fourth, the court recognized the substantial inequities that would result if S-corp status were treated as estate property. If the termination of S-corp (or QSub) status were avoidable, then any income generated by the debtor would remain with the debtor, while the tax burden could be shifted back to the shareholders. For all of these reasons, the court concluded that S-corp status is not “property” for the purposes of the Bankruptcy Code.
QSub Status Is Not Property for Purposes of the Bankruptcy Code
Turning to whether a debtor’s QSub status is estate property, the circuit court held that, a fortiori, such status cannot be estate property. Indeed, while an S-corp’s tax status is subject to the will of the shareholder, the right to enjoy QSub status is dependent upon (i) the S-corp parent owning 100% of the QSub’s stock, (ii) the S-corp parent’s decision not to revoke its subsidiary’s QSub status, and (iii) the S-corp parent’s continuing status as an S-corp. Similarly, QSub status is not transferrable (except insofar as the parent could sell 100% of the stock of the QSub to another qualified S-corp). Because QSubs are derivative of S-corps, have no control over their own tax status, and such status is not alienable or assignable, the Third Circuit concluded that QSub status is not “property” for purposes of the Bankruptcy Code.
A Debtor’s QSub Status Is Not “of the Estate”
Next, the Circuit Court held that even if tax status were considered “property,” it would not belong to the debtor’s estate, as is required pursuant to section 541 of the Bankruptcy Code. It recognized the difference between traditional C corporations and S-corps, in that an S-corp is merely a “conduit” for tax benefits that flow to its shareholders. Looking back to the NOL analogy, an S-corp does not retain its NOLs upon filing for bankruptcy because, pursuant to the Internal Revenue Code, the right to use the NOLs automatically passes through to the S-corp’s shareholders. Indeed, because a QSub has no control over its own tax status or its tax treatment (and owes no taxes), the Third Circuit observed that QSubs are virtually “nonexistent” for federal tax purposes. Accordingly, the court held that, if QSub status were property, it would be property of the S-corp parent because the parent’s shareholders maintain control over the parent’s tax status and the status of its QSub subsidiary.
Further, the court noted that treatment of QSub status as property of the debtor would necessarily place unreasonable restrictions on any nondebtor parent. If QSub status is property of the estate and must remain intact during a bankruptcy case, the nondebtor parent would lose its right to terminate its subsidiary’s QSub status, but would also lose its own right to terminate its own S-corp status (as was the case with MSC II and Barden Development). This rule would also deprive the parent of its right to sell its shares in the QSub debtor because virtually any such sale of part or all of those shares would have the effect of terminating the debtor’s QSub status. Because the Bankruptcy Code does not confer additional property interests on a debtor beyond those interests to which it is entitled as of the petition date, the court reasoned that the Bankruptcy Code cannot grant a QSub debtor the right to interfere with its nondebtor parent’s legitimate (and otherwise unrelated) business transactions. Finally, because MSC II’s QSub status was not property and did not belong to MSC II (and MSC II could not show that it had third-party standing), the Third Circuit concluded that MSC II lacked standing to even bring its action to avoid the revocation of Barden Development’s S-corp status.
In Majestic, the Third Circuit set forth an extensive discussion of the treatment of tax status in bankruptcy cases, even going out of its way so as to question all other courts to have considered whether S-corp status is estate property. Though the Third Circuit’s decision was almost certainly informed by the equities of case (insofar as the debtor stood to realize a windfall on account of tax-free income for so long as it remained a QSub, while Mr. Barden would shoulder the entire tax burden without realizing any of the benefits of MSC II’s business), it will likely have sweeping effects as other courts determine whether to follow the Third Circuit’s decision or to side with the pre-Majestic courts that have repeatedly held to the contrary.