This post examines an interesting intersection between bankruptcy and tax laws: if a corporation terminates its Subchapter S status pre-bankruptcy, can a bankruptcy trustee bring fraudulent transfer claims against the corporation’s shareholders to recover resulting tax refunds they receive?  One bankruptcy court recently dismissed such fraudulent transfer claims on the ground that the corporation’s S status wasn’t property of the debtor’s bankruptcy estate, and thus the trustee couldn’t pursue the claims. Richard Arrowsmith v. United States (In re Health Diagnostic Lab., Inc.), 2017 LEXIS 4148 (Bankr. ED Va. Dec. 6, 2017).  This decision adds to a split of authority on this issue.

Background

The debtors, Health Diagnostic Laboratory, Inc. and affiliates (HDL), provided laboratory testing services for physicians.  In 2013, federal authorities investigated if HDL had violated federal anti-kickback laws.  This led to allegations that HDL had violated the U.S. False Claims Act and that HDL settled for millions of dollars.  After that, the debtors’ fortunes got even worse.  They defaulted on loans and filed chapter 11 bankruptcy petitions.  Their assets were sold, a plan of liquidation was confirmed, and a liquidation trust was set up.

Earlier this year, the liquidation trustee sued the US Internal Revenue Service, certain state taxing authorities, and former shareholders of HDL.  The complaint alleged that HDL’s pre-petition revocation of its Subchapter S status constituted a fraudulent transfer under both federal bankruptcy law and state law.  But Bankruptcy Judge Kevin R. Huennekens rejected the trustee’s theory and dismissed the claims.  He ruled that the S status was not “property” of the HDL debtors’ bankruptcy estates. 

S corporation status is available to corporations with 100 or less shareholders and one class of stock.  All shareholders must agree to the S status. An S corporation isn’t taxed at the corporate level, but taxes are passed through to shareholders.  In contrast, in a Subchapter C corporation, there are two levels of taxation: at the corporate level and at the shareholder level. HDL had S status from 2009 until January 2015, when shareholders voted to revoke the S status.  At the petition date, HDL was a C corporation.

The Lawsuit

The liquidation trustee asserted that revocation of the S status enabled shareholders to receive tax refunds that the trustee could claw back under fraudulent transfer laws.  The trustee’s theory was based on several assumptions.  If HDL was reclassified pre-petition as an S corporation, then it would file an amended return for 2015.  Income losses would be passed through to shareholders, who likely would amend their own returns for 2015 and seek to apply unused losses back two tax years.  This would generate tax refunds for the shareholders that the liquidation trustee wanted to recover in his lawsuit.

The issue before the court was whether the S status constituted property of the debtors’ estates under Bankruptcy Code section 541.  If so, then the Trustee could pursue the fraudulent transfer claims on behalf of the estates’ creditors.  Based on case law to date, the trustee had a lot of authority on his side.  Only one court, the Third Circuit, had ruled that S status isn’t property of a debtor’s bankruptcy estate.[i]  Four other courts had held the opposite.[ii]

Judge Huennekens noted that property of the estate is broadly defined to include “all legal or equitable interests of the debtor in property as of the commencement of the case.”[iii]  Moreover, federal tax law determines if the S corporation status is a property right for purposes of the fraudulent transfer claims. 

Judge Huennekens considered six factors to determine if a property right existed: “(1) the right to use; (2) the right to receive income produced by the purported property interest; (3) the right to exclude others; (4) the breadth of the control the taxpayer can exercise over the purported property; (5) whether the purported property right is valuable; and (6) whether the purported right is transferable.”[iv]

He concluded that only one factor (the right to use) “leans in favor of classifying S corporation status as property.”[v]  But this factor, he added, is the “weakest” of the property rights available.  This is because “use” doesn’t mean “control” and thus the “right to use” in this context is "devoid of any meaningful property interest.”[vi] He noted that one who borrows and uses a neighbor’s tool doesn’t necessarily have an ownership right in it.[vii]   

None of the other factors, Judge Huennekens ruled, supported the trustee’s theory.  The rights reflected in those factors belonged largely to HDL’s shareholders and not the corporation.  Accordingly, the revocation of the S status did not confer a property right on the debtors’ estates such that the trustee could pursue the fraudulent transfer claims.

[vii] The decisions cited in note ii above reached the opposite conclusion.  Those courts ruled that S status was estate property because it was interest of a debtor that could be “used, enjoyed, and disposed of” (a definition found in a treatise and Black’s Law Dictionary). Id. at *25, n.20.