By: Erin Rieu-Sicart
St. John’s Law Student
American Bankruptcy Institute Law Review Staff
Finding that it would violate the absolute priority rule, the United States Bankruptcy Court for the Western District of North Carolina, in In re Carolina Internet, Ltd., held that an insolvent S corporation may not pay post-petition taxes on behalf of its shareholders because a corporation’s creditors have priority over its shareholders.[1] That approach highlights the problems bankruptcy creates for pass-through entities such as S corporations, because the benefits of successful post-petition operations flow to the creditors while the tax consequences of those operations are borne by the shareholders.
The factual setting did not present a very sympathetic case for the shareholders for a number of reasons, such as their receipt of several large prepetition distributions made when the corporation was allegedly insolvent.[2] In addition, Carolina Internet, Ltd. (the “Debtor”), initially filed a blanket motion for authority to use cash collateral to make subchapter S distributions to its shareholders in the amount of $45,000 per month.[3] The court rejected that request.[4] In doing so, it noted that the Debtor had only accrued $44,578.42 in North Carolina state tax liabilities, and the court had previously authorized a single distribution sufficient to pay that outstanding tax obligation.[5]
The court concluded that although a corporation may make tax payments on behalf of its shareholders under North Carolina law, it cannot continue doing so post-petition, because the absolute priority rule grants creditors the right to be paid in full before shareholders receive any distributions from the estate.[6] The court explained that the North Carolina statute allows, but does not require, an S corporation to file composite returns and pay the taxes on behalf of its shareholders.[7] Furthermore, the court held that the Debtor’s choice not to pay those taxes would not affect its status as an S corporation.[8] The court added that when a “pass through” entity, such as an S corporation, is insolvent, the shareholders themselves remain personally liable for its income tax payments.[9]
In re Carolina Internet, Ltd. supports the principle that when an S corporation files for Chapter 11 bankruptcy, it may not pay shareholders before it pays its creditors in full because of the absolute priority rule.[10] The court stated that the choice to be treated as an S corporation “comes with benefits and burdens” and electing to be taxed under subchapter S provides a solution to the problem of double taxation for a corporation’s shareholders, while the status as a “pass through” entity also gives shareholders the responsibility of paying income taxes arising from corporate operations.[11] Insolvent S corporations may be hesitant to file bankruptcy after the court’s decision in In re Carolina Internet, Ltd., because of the possible post-petition tax liabilities for which bankruptcy courts could hold shareholders responsible.[12] This decision is also likely to provide creditors of S corporations the comfort of knowing they are protected by the absolute priority rule regardless of the debtor’s status under subchapter S.
[1] In re Carolina Internet, Ltd., 11-32461, 2012 WL 2860024, at *3 (Bankr. W.D.N.C. July 11, 2012).
[2] Id.
[3] Id. at *2. “A subchapter S corporation may make a tax-free distribution to its shareholders of its income for the immediately preceding year, upon which the shareholders have paid the tax, by making a ‘distribution of money . . . on or before the 15th day of the third month following the close of such taxable year.’ I.R.C. § 1375(f).” Patton v. United States, 726 F.2d 1574, 1575 (Fed. Cir. 1984)
[4] In re Carolina Internet, Ltd., 2012 WL 2860024, at *2.
[5] Id. at *2-*3.
[6] See id. at *3. See also 11 U.S.C. § 1129(b)(2)(B)(ii) (2006) (codifying absolute priority rule).
[7] The North Carolina statute that the debtor relied on provides, in relevant part, that the “[d]epartment may permit S Corporations to file composite returns and make composite payments of tax on behalf of some or all resident shareholders” (emphasis added). See In re Carolina Internet, Ltd., 2012 WL 2860024, at *2. See also N.C. Gen. Stat. Ann. § 105-131.7 (1999). The Debtor’s position was further undermined by its failure to file composite returns before bankruptcy.
[8] In re Carolina Internet, Ltd., 2012 WL 2860024, at *2.
[9] Id. at *3.
[10] See id.
[11] See id. See also Pants Rack, Inc. v. United States, 669 F.2d 198, 200 (4th Cir. 1982).
[12] The shareholders of an insolvent S corporation can be held liable for its income tax payments, however corporations such as the debtor here can simply not require its shareholders to pay its taxes, and continue making distributions to shareholders despite insolvency. In In re Carolina Internet, Ltd., the debtor did not hold its shareholders responsible for its tax liabilities even after filing chapter 11. In re Carolina Internet, Ltd., 2012 WL 2860024, at *3.
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