Federal Court Confirms S Corporation's Flexibility for Owner's Asset Protection, Tax Savings
It's a common practice today for entrepreneurs to separate their business affairs into various entities and entity structures. Some even go so far as starting entities that own other entities—the classic holding company/operating company arrangement. Besides being a good business practice, it is also considered a high-level asset protection strategy. And recently, the federal courts confirmed it's an incredibly valuable asset protection strategy when using an S corporation election—if a subsidiary corporation goes into bankruptcy, its parent entity can end the subsidiary's pass-through tax status, leaving its debts in the subsidiary organization, instead of them passing through to the parent.
In a recent court ruling, the Chapter 11 bankruptcy of a “QSub” subsidiary corporation did not prevent the “S corporation” parent corporation from revoking pass-through tax status, under a May, 2013, decision by the Third Circuit Court of Appeals. The practical result was that the debtor-subsidiary-corporation—which by then was effectively controlled by its creditors—lost its pass-through tax status and became liable for paying its own tax. It could no longer pass taxes through to the non-debtor individual who owned 100 percent of the parent S corporation that revoked the S election.
Not surprisingly, the debtor corporation (in other words, the bankruptcy creditors) opposed the revocation, claiming that it amounted to an unlawful, post-bankruptcy-petition transfer of the debtor’s property. They sought to have the S Corp and QSub statuses reinstated.
Generally, the property of the bankruptcy estate is determined at the time the bankruptcy petition is filed.
The Court focused on whether a debtor corporation’s federal tax status is considered “property” of the bankruptcy estate. Here, the QSub subsidiary (a Delaware corporation) filed for bankruptcy, but its parent corporation, and the individual who owned the S Corp parent, did not.
Ultimately, the Court decided that S Corp status, and QSub status, is not “property” for bankruptcy purposes. A tax classification over which the debtor has no control is not property of the bankruptcy estate. Consequently, the debtor corporation could not challenge the revocation.
Other courts in other parts of the county have reached opposite conclusions. Consequently, the result in other bankruptcies may depend on location. The Third Circuit Court of Appeals hears appeals from lower courts in Pennsylvania, Delaware, and New Jersey.
S Election Revocation
Majestic Star Casino II, Inc. (“MSC II”) filed a voluntary petition for Chapter 11 bankruptcy on November 23, 2009 (“petition date”). At the time the bankruptcy petition was filed, MSC II was a QSub of Barden Development, Inc. (“BDI”), its S Corp parent, for federal tax purposes. Accordingly, the income and losses of MSC II flowed through to BDI’s sole individual shareholder (“Barden”).
MSC II was a wholly owned subsidiary of The Majestic Star Casino, LLC, which in turn was wholly-owned by Majestic Holdco, LLC. For tax purposes, BDI was treated as the owner of MSC II because the LLCs were disregarded entities.
Barden and BDI did not file bankruptcy petitions and did not participate as debtors. Sometime after the bankruptcy petition was filed, Barden caused and consented to the revocation of BDI’s S Corp status, retroactively effective to January 1, 2010, without seeking authorization from the court or the bankruptcy debtors. Consequently, MSC II’s QSub status was terminated and both BDI and MSC II became C Corporations for federal tax purposes, each responsible for paying for its own income taxes.
The debtor-corporation, effectively controlled by its creditors at this point, did not agree with MSC II’s post-revocation tax burden and tried to have the S Corp and QSub tax statuses retroactively restored.
Practical Considerations: COD Income in Bankruptcy
In general, cancellation of indebtedness can generate “cancellation of debt” income (“COD income”), which is generally taxable. A taxpayer in bankruptcy may escape paying tax on COD income under the Bankruptcy Exception. However, the trade-off for this benefit is that the debtor has to also reduce the value of other tax attributes dollar-for-dollar by the amount of COD income excluded from gross income.
The court noted that if BDI’s S Corp status were restored, then
- Barden (BDI’s shareholder) would ultimately be liable for taxes on the COD income resulting from the bankruptcy
- Barden may not qualify for the Bankruptcy Exception, since neither Barden nor BDI was part of the bankruptcy
- The IRS would lose the benefit of MSC II’s tax liabilities being treated as an administrative expense of the bankruptcy estate (which would allow the government to be paid before many other creditors)
In addition, the creditors who replaced BDI as the holders of MSC II’s equity would benefit. The court noted the difference between remaining liable for the corporation’s taxes and having access to the corporation’s income and cash flow to fund payments. Moreover, by shifting the COD tax liability to BDI, MSC II could avoid COD income tax liability without the adverse impact of the Bankruptcy Exception on other tax attributes.
Is QSub Tax Status “Property” of the Bankruptcy Estate?
Previously, courts have determined that net operating losses (NOLs) are considered “property” of the debtor for bankruptcy purposes. However, the Court here viewed S Corp tax status as different from NOLs.
According to the court, NOLs are not subject to revocation by shareholders or termination by the IRS. In contrast, S corporation tax status “is entirely contingent on the will of the shareholders.”
In addition, noted the court, the value of an NOL is either readily determinable or subject to relatively clear estimation. The value of an S election depends on future earnings and the election not being revoked. Further, NOLs may be monetized, unlike the S election.
The Court added that viewing S Corp status as a guaranteed right is incorrect. Rather, S corporation status is freely revocable, and other events may trigger loss of S Corp status.
The notion that S Corp tax status is property, simply because the status has value to the bankruptcy estate, was also rejected. “Capacious as the definition of ‘property’ may be in the bankruptcy context, we are convinced that it does not extend so far as to override rights statutorily granted to shareholders to control the tax status of the entity they own.”
Accordingly, the Court concluded that S Corp status and QSub status are not “property” of the estate for bankruptcy purposes. Even if the QSub tax status were property (it wasn’t), it would belong to the non-debtor parent S Corp, not to the debtor subsidiary. If QSub status were to be treated as the property of the debtor-subsidiary, the parent corporation would be subject to “remarkable restrictions.” It would lose
- the right to terminate the QSub election and its own S election
- the ability to sell the subsidiary’s shares to non-S Corp purchasers or to sell less than 100 percent of shares
- the ability to sell the parent to a non-S Corp entity or otherwise trigger loss of QSub status