Third Circuit Update: Subchapter S Corporation Tax Status Not Estate Property

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The Third Circuit Court of Appeals, in a case of first impression at the Circuit Court level, has determined that a subchapter S corporation tax status is not property of the corporation’s bankruptcy estate. In Majestic Star Casino LLC v. Barden Development Inc. (In re Majestic Star Casino LLC), No. 12-3200, 2013 WL 2162781 (3d. Cir. May 21, 2013), the Court overturned a Delaware bankruptcy court’s determination that a subchapter s corporation tax status was a right under the Internal Revenue Code and therefore constituted estate property under section 541(1) of the Bankruptcy Code.

The case involved a tax strategy used by Barden Development Inc. (“BDI”) to allow its owner to avoid forgiveness of debt tax liabilities resulting from Majestic Star Casino LLC’s (“MSC”) bankruptcy. Its owner and sole shareholder obtained a revocation of BDI’s subchapter S corporation (“S Corp.”) status from the IRS. The debtor, MSC, was a wholly owned qualified subchapter S subsidiary of BDI. As such, the revocation of BDI’s S Corp. status resulted in the revocation of MSC’s S Corp. status, which occurred after it filed for Chapter 11 bankruptcy protection. The result of the revocation shifted the tax liabilities from its owner back to MSC. To avoid this liability, MSC commenced an adversary proceeding seeking a determination that its S Corp. status was property of its bankruptcy estate and that BDI’s revocation resulted in a transfer of this property from MSC’s estate.

In making this determination, the Court looked at prior case law in other jurisdictions finding that S Corp. status was estate property, because it was the same type of property right as net operating losses (“NOLs”) which are property of a bankrupt corporation’s estate. The Court found this reasoning unpersuasive, because these two property rights were of an entirely different nature. The key difference was that, unlike NOLs, which are finite, vested rights not capable of IRS or shareholder termination or revocation, S Corp. pass through status “…is entirely contingent on the will of the shareholders” and can be terminated at any time “…regardless of how long it has been an S Corp. and whatever its pre-bankruptcy operating history has been.” Id. at *12. Moreover, in the case of a qualified subsidiary S Corp., the Court noted that the case was even weaker because the subsidiary had less control over its status since it relied on the parent’s continued ownership of 100 percent of its stock as well as the parent continuing to maintain its status as an S Corp.

Finally, the Third Circuit noted that even if it could find a property interest in S Corp. status, MSC did not have standing to challenge BDI’s revocation as a third party. Should this happen, the Court reasoned that it would place “remarkable restrictions on the parent,” without any basis to do so in the Internal Revenue Code or Bankruptcy Code. Id. at *16.

The case is significant in that it insulates a parent S Corp. from creditor attacks against its qualified S Corp. subsidiary, thereby shifting pass through tax burdens from the parent’s shareholders to the subsidiary, to the detriment of the subsidiary’s creditors. It also sets a new precedent with respect to the issue of tax status not being estate property, contrary to what other courts previously determined.