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Escaping Taxes in Bankruptcy Through S Corporations

Editor’s note: this blog post was recently published in Law360.

Shareholders of financially troubled S corporations may now be able to avoid the flow-through of taxes when the S corporation or its subsidiary files bankruptcy.  In In re Majestic Star Casino, LLC, 716 F.3d 736 (3rd Cir. 2013), the Third Circuit Court of Appeals ruled that an S corporation shareholder, who may have received the benefit of years of flow-through income tax treatment from the S corporation, may avoid the flow-through of taxable gain or income in bankruptcy simply by revoking the S corporation election.   The revocation converts the corporation into a C corporation, thereby trapping at the corporate level all income tax liabilities that the corporation incurs in bankruptcy.  The losers are the corporation’s unsecured creditors, whose claims will now only get paid after the tax claims the corporation incurs in bankruptcy.

In Majestic Star Casino, one of the debtors was a corporate subsidiary of an S corporation for which a qualified S corporation subsidiary (QSub) election had been made, thereby causing the debtor QSub to be treated as a disregarded entity for federal income tax purposes (akin to a division of the S corporation parent).  After the debtor QSub filed chapter 11 bankruptcy, the S corporation’s shareholder revoked the S election for the parent (which was not in bankruptcy).  This also revoked the QSub election for the debtor QSub, with both the parent and the debtor QSub becoming C corporations.

The debtors, which were effectively controlled by their creditors, sought to avoid the revocation of the S election.  The Third Circuit concluded that neither the parent corporation’s status as an S corporation nor the debtor’s status as a QSub was “property” for bankruptcy purposes.  Moreover, even if the debtor’s QSub status was property, it would not be property of the bankruptcy estate but of the S corporation or its shareholder.  As such, the debtors did not have standing to challenge the revocation of the S election.

Whether a tax attribute is property of a bankruptcy estate has long been debated.  The Third Circuit is the first circuit court to rule on whether an entity’s tax status as an S corporation is property of a bankruptcy estate, and it declined to follow a number of lower court decisions that held that an S election is property.  Those courts analogized an S election to a net operating loss that a C corporation may carry back or carry forward, which has been held to be property.   The Third Circuit disagreed, stating that unlike an NOL, an S election is “entirely contingent on the will of the shareholders” because it may be revoked or terminated at any time.  The Third Circuit added that an NOL has a readily determinable value while an S corporation status does not, and even if the S election had some value to the debtor, this alone does not equate to a property right under the bankruptcy laws.

The Third Circuit also expressed concerns that if the S corporation’s shareholder could not revoke the S election, the S corporation’s shareholder would incur undue hardship on account of having to pay tax on the flow-through of gains or income the debtor incurred in bankruptcy from the sale of assets and cancellation of debt, while the creditors receive the distributions.  The Third Circuit did not, however, address that this also occurs with partners in a partnership bankruptcy.  Even worse, while an S corporation shareholder may exclude cancellation of debt income if the S corporation (and not just a QSub, as in Majestic Star Casino) receives a discharge in bankruptcy or is insolvent, these exclusions only apply to partners of a partnership in bankruptcy if they themselves receive a bankruptcy discharge or are insolvent.  But an S corporation provides rights, including the right to revoke the S election at any time and avoid the flow-through of future taxable income, and burdens that differ from a partnership.  It therefore could be considered inequitable to eliminate a specific right afforded S corporation shareholders but not partners of a partnership.

Nevertheless, permitting an S corporation shareholder to revoke the S election also causes undue hardship to the bankruptcy estate and its unsecured creditors.  The bankruptcy estate does not get the benefit of any prior year losses, such as an NOL carryforward had the debtor always been a C corporation, to offset taxable income the corporation recognizes in bankruptcy.  Moreover, an S corporation shareholder could revoke the S election and impose a tax liability on the bankruptcy estate at any time, even post-petition, without warning or notice, which could severely inhibit the ability of the bankruptcy estate to plan for such tax liability or reorganize in a chapter 11 case.

In the end, the Third Circuit found that the S and QSub elections were not property and that the equities favored the shareholder.  While the ruling provides an advantage to those using S corporations, it also may make lenders more cautious about extending credit to S corporations.  And although the Third Circuit is influential in bankruptcy law, there are authorities in other circuits, though not at the circuit court level, to the contrary.  Thus, one can expect bankruptcy trustees and creditors to continue to vigorously oppose revocations of S elections.