S-Corp and QSub Tax Status Do Not Constitute Property of the Bankruptcy Estate

In In re Majestic Star Casino, LLC, the Court of Appeals for the Third Circuit held as a matter of first impression that a Chapter 11 debtor’s status as a pass-through entity for taxation purposes did not constitute “property” of the bankruptcy estate.[1] The debtors, Majestic Star Casino II (“MSC II”) and other subsidiaries and affiliates, were wholly owned by a non-debtor corporation called Barden Development, Inc. (“BDI”).[2]  Don H. Barden (“Barden”) was the sole shareholder, CEO, and president of BDI.[3]  In November of 2009, the debtors filed for bankruptcy under chapter 11 of the Bankruptcy Code.[4]  Later that year, Barden chose to revoke BDI’s status as an “S” corporation (“S-Corp”) for tax purposes, thus forfeiting the company’s pass-through tax status.[5]  As a result of that election, MSC II’s status as a qualified subchapter S subsidiary (“QSub”) was also automatically revoked.[6]  Thus, MSC II was now subject to federal and state taxes that it used to pass on to Barden.[7]  MSC II asserted that the revocation of BDI’s S-Corp status constituted an unlawful postpetition transfer of property of MSC II’s bankruptcy estate.[8]  The Third Circuit reversed the decision of the bankruptcy court, holding that MSC II’s status as a QSub for tax purposes was not property, and even if it was, it would belong to the shareholders of its non-debtor parent corporation and not to MSC II.[9]

 

The Third Circuit’s decision in Majestic Star Casino, was opposed the prevailing logic of many bankruptcy courts, which had found that S-Corp status was property of the bankruptcy estate.[10]  The most prominent case supporting S-Corp status as property of the estate is In re Trans-Lines West, Inc.[11]  The Trans-Lines West court based its decision in part on prior holdings that net operating losses were property of the estate.[12]  The court concluded that an election to carry forward net operating losses and an election to revoke S-Corp status were indistinguishable because both actions result in a potential increase of a debtor’s tax liability.[13]  Therefore, the court held that the revocation of a corporation’s S-Corp status constituted a transfer of the debtor’s interest in property.[14] The Third Circuit, however, disagreed with this comparison, stating that unlike net operating losses, S-Corp tax status does not have a readily ascertainable value.[15]  Furthermore, the Third Circuit criticized the Trans-Lines West court’s reasoning that S-Corp status was a “right” of the debtor protected by the Internal Revenue Code.[16]  Because the S-Corp status is contingent on a number of factors beyond the debtor’s control, and because it is not transferrable, the Third Circuit concluded that it was not a property right.[17]

 

The Third Circuit’s decision in Majestic Star Casino limited the broad interpretation of “property of the estate” under section 541.[18]  Although the Third Circuit recognized that the definition of property of the estate was intended to be broad, the court declined to extend the concept of “property of the estate” to override the statutorily granted right of shareholders to control the tax status of an entity that they own.[19]  The practical effect of this is that it allows an owner of a parent company to shift substantial tax liabilities from himself to his debtor subsidiaries by validly revoking its S-Corp status.  Accordingly, there will be an additional claim in the debtor’s bankruptcy case.  As a result, creditors will likely receive lower distributions than they would have if the S-Corp status had been retained.

 

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