QSub Status Is Not Property of Bankruptcy Estate 

    TAX TRENDS 
    by James A. Beavers, J.D., LL.M., CPA, CGMA 
    Published August 01, 2013

    Bankruptcy & Insolvency

    The Third Circuit held that an S corporation’s revocation of its S corporation status, which caused its QSub subsidiary to lose its status as a QSub, was not a post-bankruptcy-petition transfer of property of the QSub’s bankruptcy estate.

    Background

    Barden Development Inc. (BDI) was an Indiana corporation that had elected to be treated as an S corporation. Barden was owned by Don Barden (Barden). BDI was the owner of Majestic Star Casino II Inc. (MSC II), the owner and operator of a hotel and casino in Gary, Ind.

    In 2009, MSC II filed a petition for bankruptcy. MSC II’s debtors became the debtors-in-possession of the bankruptcy estate. At the time the petition was filed, BDI and MSC II remained an S corporation and a QSub. However, Barden, without informing the MSC II debtors or the bankruptcy court, subsequently revoked BDI’s S corporation election as of Jan. 1, 2010. This caused a termination of MSC II’s QSub status. Thus, both BDI and MSC II became C corporations as of Jan. 1, 2010, and, as a consequence, MSC II became responsible for filing its own tax returns and paying income taxes on its holdings and operations. This had the practical effect of transferring MSC II’s tax burden from Barden (through BDI) to the MSC II debtors.

    Unsurprisingly, the MSC II debtors were not pleased with this turn of events, and they filed a complaint with the bankruptcy court against BDI, Barden, the Indiana Department of Revenue, and the IRS (the defendants), asserting that the revocation caused an unlawful postpetition transfer of MSC II’s bankruptcy estate property. The complaint sought recovery of that “property” through an order directing the IRS and the Indiana Department of Revenue to restore BDI’s status as an S corporation and MSC II’s status as a QSub retroactively effective to Jan. 1, 2010.

    The Bankruptcy Court’s Decision

    The Bankruptcy Court held that MSC II’s status as a QSub was the property of MSC II, and that, as such, it belonged to MSC II’s bankruptcy estate. The court therefore concluded that the revocation by nondebtor BDI of its status as an S corporation, and the resulting termination of MSC II’s status as a QSub, were void and of no effect. Finally, the court ordered the defendants, including the IRS, to take all actions necessary to restore the status of MSC II as a QSub of BDI.

    The bankruptcy court found that QSub status is analogous to S corporation status and, based on In re Trans-Lines West, Inc., 203 B.R. 653 (Bankr. E.D. Tenn. 1996), and several other cases, which held that S corporation status is property, concluded that QSub status was also property. The court in Trans-Lines West, Inc., found that S corporation status was property because the ability to make an S corporation election closely resembled the ability to elect to carry forward or carry back a net operating loss (NOL) deduction, which the Supreme Court in Segal v. Rochelle, 382 U.S. 375 (1966)(carrybacks), and the Second Circuit in In re Prudential Lines, Inc., 928 F.2d 565 (2d Cir. 1991) (carryforwards), held to be property under the Bankruptcy Code.

    The defendants appealed the bankruptcy court’s decision to the Third Circuit.

    The Third Circuit’s Decision

    The Third Circuit reversed the Bankruptcy Court and held that MSC II’s status as a QSub was not property for bankruptcy purposes and, even if it was, it was not property of MSC II. Because it found that QSub status was not MSC II’s property, the court did not consider whether the revocation of BDI’s S corporation status was a transfer. The court also held that, having determined that QSub status was not property, MSC II did not have standing to challenge the revocation of its QSub status by BDI.

    Because there was no case law on the point, to determine whether QSub status was property, the Third Circuit analyzed the case law regarding whether S corporation status was property. The court found that the Trans-Lines West decision and others that followed it had not properly considered the differences between an NOL and S corporation status in extending the principle that NOLs are property for bankruptcy purposes to S corporation status. It noted that while the existence and amount of a corporation’s NOLs were fixed prior to the filing of a bankruptcy petition, a corporation’s S status was contingent on the will of the shareholders and could be terminated at any time, regardless of the corporation’s prebankruptcy history.

    The Third Circuit also found, contrary to the Trans-Lines West decision, that S corporation status was not a right guaranteed by law because the shareholders as a whole could revoke S status at will or an individual could cause a revocation unilaterally by selling stock to an ineligible shareholder. In addition, the Third Circuit rejected the idea that any right of a debtor that has value is property and found that a tax classification over which the debtor has no control did not rise to the level of property.

    With regard to QSub status, the Third Circuit concluded the same arguments that applied to S corporation status applied, only more so, because a QSub had even weaker control over its status than an S corporation due to the fact that the continuance of QSub status depends on factors that are not only entirely outside of the QSub’s control but also entirely outside of its S corporation parent’s control. The court also maintained that QSub status should not be considered property because a QSub cannot transfer or otherwise dispose of its QSub status.

    The court then discussed whether, if QSub status was considered property, it would be property of the QSub and therefore property of the bankruptcy estate. The court determined that it would be property of the QSub’s S corporation parent, not the QSub. The court based its determination on the characteristics of a QSub under federal tax law and the fact that under the law the S corporation parent controlled the QSub election and suffered the tax consequences, good or bad, of making the election. The court also found that treating QSub status as property of a QSub in bankruptcy would place significant restrictions on the rights of the S corporation parent that had no foundation in the Internal Revenue Code or the Bankruptcy Code.

    Finally, having decided that MSC II’s QSub status was not property of its bankruptcy estate, the Third Circuit addressed whether the QSub had standing to challenge the revocation of its QSub status by its parent, BDI. According to the court, because the status was not property, MSC II would be asserting the rights of a third party, its S corporation shareholder, which it could do only if it had third-party standing. To support its argument that it had third-party standing, MSC II was required to show that BDI was hindered from asserting its own rights and shared an identity of interest with MSC II. The court found that BDI had effectively defended its rights to revoke its own S corporation status (and by extension MSC II’s QSub status) and that instead of having an identity of interests, the interests of BDI and MSC II were diametrically opposed. Therefore, MSC II did not have third-party standing to challenge the revocation of its QSub status.

    Reflections

    At first glance, whether S corporation status or QSub status is property would seem to be an easy question. However, as this case shows, courts have pushed the boundaries of what is property for bankruptcy purposes so far that plausible arguments can be made either for or against the proposition.

    The Majestic Star Casino, LLC v. Barden Development, Inc., Nos. 12-3200/3201 (3d Cir. 2013)




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