Buyer Beware: S-Corp Status Can Be Revoked Anytime; Even in Bankruptcy

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One of the best-known features of bankruptcy law is the automatic stay, which prevents a variety of actions to collect debts and to take possession or control of anything considered “property of the estate.” However, one thing that may not be considered property of the bankruptcy estate is the S-corporation (“S-corp”) status of a corporate debtor. Although at least two Bankruptcy Appellate Panels have found that the S-corp status of a debtor is property of the bankruptcy estate, the Third Circuit’s leading, and most recent decision on point, rules otherwise. Compare In re Majestic Star Casino, LLC, 716 F.3d 736 (3rd Cir. 2013) (holding that S-corp status is not property of the estate); with In re Bakersfield Westar, Inc., 226 B.R. 227 (B.A.P. 9th Cir. 1998) and In re Funaro, 263 B.R. 892 (B.A.P. 8th Cir. 2001) (holding that S-corp status is property of the estate).

This distinction may be critical to parties seeking to buy assets from a bankruptcy estate and creditors hoping for a distribution. If the corporate pass-through tax status is not property of the bankruptcy estate, then the power to revoke that status lies entirely with the shareholders. As a result, shareholders who want to avoid the tax liability incurred by a debtor for the sale of assets or cancellation of debt in bankruptcy can, without warning or notice, revoke the debtor’s S-corp status and leave the bankruptcy estate liable for the taxes. Even worse, the debtor will not be able to take advantage of losses from prior years to reduce its tax liability. Because post-petition tax liability must be paid on a priority basis, the revocation of pass through tax liability could significantly impact the recovery of creditors, and depending on the purchase agreement negotiations, result in a higher sale price.

Although the current case law indicates a split in authority, the consequences of revocation of S-corp status mean that buyers, creditors, trustees and corporate debtors should not leave this issue to chance. If you are dealing with a debtor that is an S-corporation, you should be cautious about any transaction that could incur tax liability, and negotiate with shareholders in advance to avoid S-corp status revocation.

Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this blog is general in nature and is not offered and cannot be considered as legal advice for any particular situation. The author has provided the links referenced above for information purposes only and by doing so, does not adopt or incorporate the contents. Any federal tax advice provided in this communication is not intended or written by the author to be used, and cannot be used by the recipient, for the purpose of avoiding penalties which may be imposed on the recipient by the IRS. Please contact the author if you would like to receive written advice in a format which complies with IRS rules and may be relied upon to avoid penalties.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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