Equityholder's Strategy for Shifting Tax Burdens to Creditors Upheld by Third Circuit

by Sheppard Mullin Richter & Hampton LLP

In re Majestic Star Casino, LLC, F.3d 736 (3rd Cir. 2013), the U.S. Court of Appeals for the Third Circuit broke from other courts by holding that S corporation status (or "qualified subchapter S subsidiary" or "QSub" status) is not property of the estate of the S corporation's bankruptcy estate. Other Circuits have routinely held that entity tax status is property of the estate.

In Majestic, Majestic Star Casino II, Inc. ("MSC II"), along with several of its affiliates (collectively, the "Debtors") was controlled by Barden Development, Inc. ("BDI"), whose sole shareholder was Don H. Barden ("Barden"). The Debtors, not including BDI or Barden, filed for bankruptcy under Chapter 11 in Delaware Bankruptcy Court on November 23, 2009.

S corporations and QSubs, as flow through entities, are entities that do not pay income taxes directly. Instead, their shareholders pay income taxes for the income that flows through to them from such entities. C corporations are responsible for paying their own income taxes. Before filing, BDI was an S corporation and MSC II was a QSub. After filing, however, Barden successfully petitioned with the Internal Revenue Service (the "IRS") to revoke BDI's S corporation status, which automatically terminated MSC II's QSub status.

At stake was the allocation of cancellation of debt income of $170 million arising from the reduced debt in the bankruptcy. Without the revocation of flow through entity status, Barden would have been liable for income taxes for the recognition of $170 million in Debtors' cancellation of debt income flowing through to him. In contrast, with the revocation, the creditors of the Debtors who replaced BDI as the equity holders of MSC II, would lose significant value in the Debtors. Such cancellation of debt income would decrease Debtors' various tax attributes that would have been available to reduce future taxes.

After Barden's successful revocation of flow through entity status, the Debtors filed an adversary complaint in the bankruptcy court that argued that the revocation caused an unlawful postpetition transfer of MSC II's estate property. The Debtors moved for summary judgment, which the bankruptcy court granted. The bankruptcy court, along the lines of precedent, held that MSC II's QSub status was property of MSC II and therefore, belonged to the bankruptcy estate of MSC II. The bankruptcy court ordered that all actions be taken to restore MSC II's QSub status by restoring BDI's S corporation status.

The IRS, Barden and BDI appealed directly to the Third Circuit. The Third Circuit vacated the bankruptcy court's order and remanded the matter with directions to dismiss the Debtors' adversary complaint. The court acknowledged that property of the estate as defined under Section 541(a) of the Bankruptcy Code contains "all legal or equitable interests of the debtor in property as of the commencement of the case," which broadly construes debtor property. However, the court went on to provide that a bankruptcy filing does not create new property rights for the debtor and concluded that entity tax status is not a property right of the bankruptcy estate.

In so holding in a case of first impression in the Third Circuit, the court reasoned that although certain tax items, such as net operating losses are property of the bankruptcy estate, entity tax status cannot be analogized to such items because entity tax status is not a right that is quantifiable like net operating losses. Further, unlike net operating losses, entity tax status can be revoked by the corporation's shareholders.

Moreover, the court reasoned that QSub status was even more removed from being property than S corporation status because QSub status also required that the shareholder of its parent S corporation continued to fully own the QSub, in addition to not having the S corporation shareholder revoke S corporation status. The court reasoned that MSC II's QSub status could not be property because it is Barden, rather than MSC II, who has control of the tax status of the entity it owns.

The court also provided equitable reasons that the cancellation of debt income should affect the Debtors rather than Barden. Because it is the Debtors, and ultimately their creditors, who benefit from the bankruptcy, it would be inequitable for Barden to pay income taxes for income that flows through to him for income tax purposes, but actually benefits the creditors of the Debtor. The court also found that it would be inequitable for Barden to be restricted from revoking BDI's S corporation status when BDI did not join in the bankruptcy petitions.

Majestic highlights the importance for equityholders of choosing the state of formation for "pass-through" entities for income tax purposes, as well as the selection of venue for a chapter 11 filing in the event such pass-through entities subsequently encounter financial distress, inasmuch as these decisions can be dispositive of which party will economically bear the burden of income taxes incurred on sale or liquidation of assets of the bankruptcy estate. Similarly, creditors to such entities must be cognizant of this risk and give consideration to commencing an involuntary bankruptcy petition against such entities outside of the Third Circuit.

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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