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.
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