[author: Nathan Gusdorf]

The Bottom Line

A recent case from the Western District of Wisconsin, In re Schroeder Brothers Farms of Camp Douglas LLP, may raise a new issue for the bankruptcy treatment of tax attributes in flow-through entities.^[1] The court in Schroeder Brothers invoked the absolute priority rule to prevent a debtor partnership from electing to be treated as a corporation for tax purposes. It found that the election would impermissibly benefit the owners at the expense of the creditors. The case arose amid a divided body of appellate case law addressing whether an entity’s tax status is a property interest of the bankruptcy estate. By raising the absolute priority rule, the Schroeder Brothers court introduced a novel approach that could affect future decisions on the bankruptcy treatment of tax attributes.

What Happened?

Schroeder Brothers Farms of Camp Douglas LLP (the Debtor), a family farm, filed a Chapter 11 petition in November 2016. The court confirmed its bankruptcy plan in June 2018, and by August 2018 the Debtor was struggling to make the payments due under the plan. The Creditors Committee moved to appoint a liquidating trustee. The Committee was concerned that the Debtor had sold none of its assets, leaving it without funds to make payments under the plan.

The Debtor opposed appointment of a liquidating trustee on the ground that asset values had plunged to the point where a liquidation in chapter 11 would produce proceeds insufficient to pay administrative expenses and taxes payable on capital gains.  The Committee replied that the Debtor was a partnership and thus the farmers, as partners, were responsible for the taxes (because a partnership’s income is taxed to the partners). 

The Debtor responded that it would elect to be treated as a corporation for income tax purposes and convert the case to chapter 12, which treats tax claims against family farms as unsecured claims. This would have shifted the tax burden of any income from the asset sales from the Debtor’s partners to the Debtor itself.

The bankruptcy court prohibited the Debtor from making the tax election. Citing the absolute priority rule in the Bankruptcy Code, the court concluded that the effect of such a tax election would be to give a benefit to the partners at the expense of the creditors. The partners would reduce their own tax liability, and the creditors would be left with less value overall.

The Schroeder Brothers decision cites no cases dealing with the bankruptcy treatment of entity tax attributes, but there is divided jurisprudence going back to 1996 on a nearly identical issue. In 1996, the Bankruptcy Court for the Eastern District of Tennessee ruled in favor of a bankruptcy trustee who sought to avoid a pre-petition termination of the debtor’s S corporation status, thereby preventing the debtor from ending its flow-through tax treatment (Trans-Lines West).^[2] The debtor S corporation had revoked its S election about a month prior to filing its Chapter 11 petition. An S corporation is also a flow-through entity for tax purposes, and the effect of the termination would have been similar to that of the Debtor’s corporate election in Schroeder Brothers. The bankruptcy trustee invoked his powers under Section 548 of the Bankruptcy Code to avoid transfers for the two years prior to the filing of the bankruptcy petition, arguing that termination of the S election was a fraudulent transfer. The court ultimately found in favor of the bankruptcy trustee, subject to certain factual findings at trial.

The central issue in Trans-Lines West, on which all of the related cases also turn, is whether an S election is an interest of the debtor in property. In order to find that the termination of the S election was a fraudulent transfer, the S corporation status itself had to be property. The court reasoned that an S corporation, under the Internal Revenue Code, has the guaranteed, indefinite right to use its S corporation status until the election is terminated. In the court’s view, this was good enough to make it a property interest. The court drew on prior case law from the Eighth Circuit that treated a debtor’s net operating losses (NOLs) as property of the bankruptcy estate, concluding that there was no consequential difference between the estate’s NOLs and its S corporation status.^[3]

Since Trans-Lines West, three circuit courts have ruled on the same issue — whether the decision to terminate an S election can be avoided by a bankruptcy trustee. As in Trans-Lines West, the analysis turns on whether the election is treated as an interest of the debtor in property. The Eighth and Ninth Circuits have come down on the side of the creditors, finding that S corporation status is a property interest. Both circuits echoed the reasoning of the court in Trans-Lines West. In In re Bakersfield Westar (B.A.P. 9th Cir. 1998), the corporate debtor’s shareholders had revoked the entity’s S election 13 days prior to its filing for bankruptcy.^[4] The bankruptcy trustee initiated a proceeding to avoid the revocation as a fraudulent transfer under Sections 544 and 548 of the Bankruptcy Code, arguing that the election had been revoked to shift the capital gains tax burden from the sale of the debtor’s assets. The IRS opposed the trustee, taking the position that the Treasury regulations provide the sole means by which an S election can be rescinded. The court rejected the IRS’s view and, citing Trans-Lines West, reasoned that because the S corporation has the right to use and enjoy its S corporation status until it terminates such status, the status is property of the corporation. In In re Funaro (B.A.P. 8th Cir. 2001), the Eighth Circuit also concluded that an S election is property of the bankruptcy estate, citing the reasoning of the Ninth Circuit in Bakersfield Westar.^[5]

The split in the circuit courts’ treatment of this issue arose in 2013, when the Third Circuit came out the other way in In re Majestic Star Casino, LLC (3d Cir. 2013).^[6] Majestic Star involved a somewhat more complex set of factual issues. The debtor, MSC II, was a qualified S corporation subsidiary (a QSub) of a parent S corporation, Barden Development, Inc. (BDI), itself wholly owned by Don Barden. A QSub, like an S corporation, is a flow-through entity for federal income tax purposes. MSC II filed a petition under Chapter 11 of the Bankruptcy Code, after which BDI terminated its S election. This automatically terminated the QSub status of MSC II, as only an S corporation is permitted to have a qualified S corporation subsidiary. Debtor MSC II would now be taxed as a C corporation, and any gains on asset sales would be taxed at the entity level rather than passed through to the original owner, Don Barden. The creditors filed an adversary complaint, arguing that the sequence of events terminating the debtor’s S election was an unlawful post-petition transfer.

Departing from its sister circuits, the court in Majestic Star found that an S election (and thus a QSub election) is not property. The court specifically rejected the analogy to a debtor’s NOLs, which it viewed as far less contingent than an S election, better defined and determined by the debtor’s operations prior to bankruptcy. By contrast, the court observed, the shareholders of an S corporation can terminate its pass-through status at will, its value is contingent on the amount and timing of future earnings, and its S election (unlike its NOLs) will generally terminate upon sale. More interestingly, the court rejected the main argument of Trans-Lines West, as echoed by the Eighth and Ninth circuits. Whereas those courts had embraced the view that the Internal Revenue Code guarantees and protects an S corporation’s right to use and enjoy that status at will, the court in Majestic Star observed that the shareholders of an S corporation may terminate the election at will and that any individual shareholder could terminate the election simply by selling his or her interest to an ineligible shareholder (such as a corporation or a nonresident alien). In the eyes of the Third Circuit, this indicated that the S corporation status is not truly guaranteed and protected and does not rise to the level of a property right. Furthermore, the court rejected the argument that S corporation status is property simply because it has value to the debtor’s estate, concluding that just because a statutory right has some value does not necessarily mean it is property.

A few district courts have looked at this issue, each following one side or the other of the circuit split. A 2017 case from the Eastern District of Virginia, In re Health Diagnostic Lab., Inc. v. Arrowsmith, follows Majestic Star, while adding new analysis that bears repeating here.^[7] Drawing on traditional Fourth Circuit property jurisprudence and the familiar “bundle of sticks” metaphor, the court concluded that S corporation status lacks most of the characteristics of a property right — shareholders possess the “right to use” S corporation status but lack the “right to control” it, as it exists only until termination; the tax classification has value, but its value is to the shareholders rather than to the corporation itself; there is no “right to exclude” because any corporation can make or terminate the election, as it is just a statutory right (unlike, in the court’s view, a net operating loss); and finally, there is no “right to transfer” because an S election is not transferrable. In contrast, Walterman Implement v. Walterman, 2006 Bankr. LEXIS 921 (Bankr. N.D. Iowa 2006) followed the Eighth and Ninth circuits in finding that S corporation status is property of the bankruptcy estate.

Why This Case Is Interesting

Schroeder Brothers departs markedly from this body of case law in ignoring entirely the issue of whether entity tax status is property. The absence of citations to the existing case law on this issue and the simplicity of the holding suggest that the court simply looked at the equities and drew what it took to be the obvious conclusion. The court cites the absolute priority rule of the Bankruptcy Code as authority for prohibiting the election, but the analysis focuses almost entirely on the economic effects of the election.

Smaller factual differences may have also motivated the holding in Schroeder Brothers. It appears to be the only case to date in which a partnership’s tax status is at issue, with the debtors seeking to elect a change in tax treatment. While the entity tax status of a partnership is elective under the check-the-box rules, a partnership defaults to flow-through treatment. This contrasts with S corporation status, which requires an affirmative election and thus might be more readily seen as a property right. In principle, the outcome should not depend on whether an S corporation or a partnership is the debtor or on when in the process the election is made, but these factors may color a court’s perception of the issue.

The court’s reliance on the absolute priority rule results from a difference in procedural posture. In the cases discussed above, entity tax elections were made (or terminated) before the bankruptcy plans were approved. Those courts had to determine whether a trustee had the power to void the elections, which required finding that the entity’s tax status was property and so within the scope of the trustee’s power. Here, by contrast, the court had to decide whether to permit the tax election, so the issue of whether the entity’s tax status was property obviously did not arise.

Nonetheless, the same issue should arise here as a doctrinal matter. If the absolute priority rule would apply to prohibit a tax election, even if the elective status is not property, strange consequences would result. In the Third Circuit, where S corporation status is not property under Majestic Star, debtors would be able to make an entity election before approval of the plan, as they would be protected from the actions of the bankruptcy trustee, but not after approval of the plan, due to the absolute priority rule. However, if an elective tax status is a statutory right retained by the owners of the debtor entity and not part of the bankruptcy estate, then one would expect it to be subject either to the whole bankruptcy process or to no part of the process.

The factual circumstances here are unusual, in that a debtor seeking to change its entity tax status will typically do so before filing a bankruptcy petition. Still, the case raises an issue of continuing significance about the intersection of the bankruptcy process and entity classification for tax purposes.

^[1] _{2019 Bankr. LEXIS 1705 (W.D. Wisc. May 30, 2019).}

^[2] _{Trans-Lines West, Inc. v. Lines, 203 B.R. 653 (Bankr. E.D. Tenn. 1996).}

^[3] _{Gibson v. United States (In re Russell), 927 F.2d 413 (8th Cir. 1991) (holding that a debtor’s election to carry forward NOLs is a transfer under Section 548 of the Bankruptcy Code).}

^[4] _{Parker v. Saunders (In re Bakersfield Westar, Inc.), 226 B.R. 227 (B.A.P. 9th Cir. 1998).}

^[5] _{Halverson v. Funaro (In re Funaro), 263 B.R. 892 (B.A.P. 8th Cir. 2001).}

^[6] _{Majestic Star Casino, LLC v. Barden Dev., Inc. (In re Majestic Star Casino, LLC), 716 F.3d 736 (3d Cir. 2013).}

^[7] _{In re Health Diagnostics Lab., Inc. v. Arrowsmith, 587 B.R. 552 (Bankr. E.D. Va. 2017).}