The Calm Before?
I’m confused.[i] For better or worse, I’m pretty sure that I am not alone.
Last week, in a letter addressed to the American people, forty-six of the fifty Republicans in the U.S. Senate indicated they would not vote in favor of increasing the federal debt ceiling to accommodate the additional spending that is called for under the $3.5 trillion Budget Resolution recently passed by Senate Democrats.[ii] If the Democrats require such an increase in the deficit to fund their programs – as described in the Administration’s American Jobs and American Families Plans[iii] – the letter explained, they will have to do so without Republican support, using the reconciliation process, in much the same way the Democrats will be increasing taxes[iv] to help cover the cost of those programs.
Not to be upstaged by Senate Republicans, several moderate[v] Democrats in the House of Representatives[vi] decided to take a stand against Speaker Pelosi on Friday. Whereas Ms. Pelosi – in union with the more “progressive” wing of her Party – has insisted the House will not vote on the bipartisan infrastructure bill already cleared by the Senate unless and until the Senate also passes the much larger social benefits bill that is the subject of the $3.5 trillion Budget Resolution,[vii] these moderates have stated they may not support the Budget Resolution unless the House first passes the infrastructure bill.[viii]
How is the economy responding in the face of this political and legislative uncertainty? How is the prospect of significant tax increases and nearly unparalleled deficit spending informing investment and business decisions? Well, the stock market appears to be oblivious to these threats as it continues to climb to new heights. Likewise, private equity investment is mounting as firms use their large pools of cash, not to mention low interest rates, to acquire closely held quality companies, a trend that is expected to continue through the rest of the year.[ix]
As 2020 ended, I expected to see an uptick in business bankruptcies – I know for a fact I was not the only one. During 2020, many law firms started beefing up their bankruptcy and restructuring groups in anticipation of such a scenario.[x] After all, the economic downturn that accompanied the pandemic was unprecedented and was keenly by most individuals and businesses felt notwithstanding the government’s efforts.
Well, guess what? Although filings for business reorganizations under Chapter 11 of the bankruptcy code[xi] increased by about 18 percent for the 2020 calendar year,[xii] business filings for the twelve months ending March 31, 2021 fell almost 14 percent compared to the same period last year.[xiii]
Yes, I am confused. That said, there is some research out there which indicates, “by all metrics, corporate financial distress is set to increase.”[xiv]
A Glimpse into the Future?
Assume for the moment we are not yet out of the woods[xv] – perhaps we have not yet even entered them.[xvi] In the case of a financially challenged business, there are many tax-related considerations to which both the business and its creditors will have to be attuned. A recent decision of the Bankruptcy Court examined what, to a casual observer, may have seemed an innocuous act.[xvii]
Debtor Entity (or “Debtor”) filed a voluntary petition and plan of liquidation under Chapter 11, following which the Court appointed a Trustee for the liquidating trust.[xviii]
The Trustee filed a complaint against LLC’s owners seeking the recovery of various transfers that the Trustee alleged were fraudulent and/or preferential transfers within the meaning of the bankruptcy code. Among the transfers identified were pre-petition distributions by Debtor Entity to its owners to enable them to pay the income taxes on their share of the revenue generated by Debtor Entity (“Tax Distributions”).
The Court explained that Debtor was originally formed as a limited liability company that was treated as a partnership for tax purposes;[xix] it subsequently converted to a C-corporation.[xx]
Debtor LLC was unprofitable at first, but when it looked as though the business was going to round the proverbial corner, it was proposed that the business be converted back into a pass-through entity (“PTE”)[xxi] for tax purposes.
The conversion from a C-corporation back into a PTE required owner approval. Many of Debtor’s owners, however, were concerned about the nature of a PTE, which required the owners to include on their tax returns their share of entity profits regardless of whether such profits were distributed to them. Specifically, they feared Debtor would not distribute to them the cash which the owners needed in order to pay the income taxes attributable to their pro rata share of Debtor’s profits.
To assuage these fears, certain owners sought, and obtained, assurances from LLC that, if the owners voted to approve the conversion, Debtor would make such distributions based upon the maximum income tax rate applicable to the Debtor income allocated to them.
The owners approved the conversion, and Debtor was reorganized as a PTE for tax purposes.[xxii]
The Debtor’s operating agreement provided:
“The [owners] shall be entitled to receive distributions from the Company only at the following times:
(1) With respect to any taxable year prior to the year in which the Company liquidates or sells all or substantially all of its assets, the Company will use reasonable efforts to distribute to each [owner] on an annual basis, and, in the discretion of the Management Board, quarterly, an amount of cash (calculated in accordance with the terms of this Section [ ] that is sufficient to cause each [owner] to have received under this Section [ ] with respect to such year aggregate distributions equal to the product of the Tax Rate multiplied by the federal taxable income allocated to such [owner] for such year (such distribution the ‘tax distributions’).”
Liquidating Trustee’s Position
Trustee challenged the assertions made by the owners that (1) “the vote to convert would not have succeeded absent the [Debtor’s] representation it would distribute funds sufficient to pay the pass through tax;” (2) the Debtor Entity’s agreement created a liability on Debtor’s part to pay the Tax Distributions; (3) Debtor “made, and the [owners] received, the Tax Distributions in good faith;” and (4) “the general unsecured creditors would have been in roughly the same position had the [Debtor] remained as a C-Corp paying taxes as it was with [Debtor] providing the [owners] the means to pay the tax on [Debtor’s] profit.”
The owners argued that Debtor Entity received “reasonably equivalent value” for the Tax Distributions. Their principal contention was that the Tax Distributions were mandatory under their agreement with Debtor, and that Debtor discharged a contractual obligation by making the Tax Distributions. The owners also argued that creditors were no worse off as a result of the Tax Distributions, because the Tax Distributions were offset by the corporate-level tax Debtor avoided by converting to a PTE, and the conversion only came about because the owners were promised the Tax Distributions.[xxiii]
Trustee argued that the above-referenced agreement only required Debtor to “use reasonable efforts” to make the Tax Distributions and characterized that language as “not mandatory” and “simply permissive and discretionary.” Trustee also contended that it was unreasonable under the circumstances for Debtor Entity to make the Tax Distributions, and thus exceeded the obligations created by the agreement. Trustee also contended that, as a matter of law, even apparently mandatory tax distributions could not amount to an “antecedent obligation.”
Reasonably Equivalent Value
The Court explained that the bankruptcy code authorizes the avoidance of transfers of interests in a debtor’s property occurring within two years prior to the petition date as fraudulent conveyances if the debtor “received less than a reasonably equivalent value in exchange for such transfer or obligation,” and was insolvent on the date that such transfer was made, or such obligation was incurred.” Trustee, the Court stated, had the burden of proving, by a preponderance of the evidence, that Debtor did not receive reasonably equivalent value for the transfer.
Notwithstanding the above analysis, Trustee contended that the Tax Distributions were not for reasonably equivalent value because the agreement did not embody a mandatory agreement to make Tax Distributions. In other words, Trustee contended that even if the owners and Debtor agreed to a quid pro quo for the conversion to PTE status, the governing language in the agreement was “plainly not mandatory” and therefore the bargained-for consideration was illusory. Instead, Trustee argued that the Tax Distributions were discretionary or simply permissive.
The Court disagreed.
The Court began by examining the prefatory language in the above-quoted paragraph from the agreement. This language, the Court concluded, was mandatory – “shall be entitled.” The language was not discretionary, the Court stated. This was confirmed, according to the Court, by the statement later in that provision which reads, in relevant part, the Debtor Entity “shall determine in good faith the amount of the Tax Distributions required by this Section [ ], and such determination shall be final and binding.” Moreover, Trustee’s reading of the words “shall be entitled” as discretionary would make unnecessary, the Court continued, any further discretion with respect to the actual timing of the Tax Distributions. Nor are the Tax Distributions subject to Debtor’s reasonable efforts. The Court pointed out that the phrase “reasonable efforts” governed the timing of the distributions: “the Company will use reasonable efforts to distribute to each Member on an annual basis . . . [Tax Distributions].” According to the Court, Trustee failed to give any meaning to the prefatory language mandating distributions in years in which the business was not liquidating and jumped over it to the timing of the distributions.
In sum, the owners were “entitled to” Tax Distributions and Debtor was obligated to “use reasonable efforts” to effect Tax Distributions on an annual basis, though Debtor had discretion to issue them quarterly.
Again relying on the argument that “reasonable efforts” was the controlling language vis-à-vis the Tax Distributions, Trustee argued that while the owners may have bargained for mandatory tax distributions in exchange for their vote on the PTE conversion, in the drafting process any mandatory commitment was watered down. Trustee argued that “reasonable efforts” meant that Debtor was only obligated to issue the Tax Distributions if it was reasonable to do so.
The Court rejected Trustee’s argument, stating that Trustee misinterpreted the meaning of “reasonable efforts” in the context of the agreement. According to the Court, the question was not whether it was unreasonable from a managerial perspective for Debtor to issue Tax Distributions in light of its liabilities; rather, the question was whether issuing the Tax Distributions required an unreasonably high effort from Debtor, thus exceeding its obligation under the agreement. Put differently, the question was whether Debtor reasonably could make the Tax Distributions, not whether it reasonably should have made the Tax Distributions.
The Courted observed that Debtor had the cash on hand that it needed to make the Tax Distributions. Nor was there any evidence that making the Tax Distributions caused Debtor to incur debt or to default on other commitments, acts which might amount to “unreasonable effort” exceeding Debtor LLC’s obligation under the agreement. Further, Debtor did not create new problems for itself by distributing its unencumbered cash pursuant to the procedures mandated in the agreement. The problem that Trustee pointed to as rendering the Tax Distributions “unreasonable” – the Debtor’s liability – existed in its unliquidated state regardless of the Tax Distributions. Thus, Debtor was obligated to make the distributions.[xxiv]
With that, the Court found that Debtor had agreed it would make distributions for taxes on passed-through income as a condition to gaining acceptance from a group of owners for conversion to a PTE. According to the Court, the owners provided reasonably equivalent value because the Tax Distributions were a bargained-for exchange in connection with an owner-approved conversion of Debtor from a C-corporation to a PTE.
Thus, the pre-petition Tax Distributions could not be avoided as fraudulent conveyances.
The consideration provided to Debtor was the agreement by its owners to tax the entity as a PTE, provided Debtor paid the pre-petition personal income taxes attributable to the owners’ share of Debtor’s pass-through income. The conversion to a PTE represented a change in taxable status and was a continuing benefit to the formerly taxable C-corporation – it did not have to pay corporate-level tax – and a continuing obligation on the part of Debtor to reimburse the owners.
By contrast, if the shareholders of a debtor S-corporation had chosen to maintain the corporation’s PTE status – which meant the shareholders were personally liable for the taxes on the corporation’s profits – it would have been improper for the debtor to make tax distributions and essentially pay the shareholders’ personal tax obligations. There would have been no consideration provided to the debtors for these distributions.
Indeed, although not discussed in the Court’s opinion, it is very likely that, following the submission of its petition, Debtor was prohibited from making any distributions to its owners. Therefore, the owners continued to be subject to income tax on the pass-through of any income from Debtor, but without the benefit of Tax Distributions.
Under those circumstances – pass-through income but no tax distributions – could the owners have revoked Debtor’s PTE status and, thus, returned Debtor to taxable C-corporation status, thereby eliminating their personal income tax liability and the resulting cash outflow? Would it make a difference under the bankruptcy rules whether the revocation occurred pre-petition versus post-petition?[xxv]
At the end of the day, it will behoove the closely held business entity debtor – whether a tax partnership, S-corporation, or C-corporation – and its owners to consult their tax and bankruptcy advisers well before approaching the entity’s creditors or filing a petition, and to thoroughly analyze the foregoing issues, as well as other tax-related matters.
[i] Yes, there are those who believe this is my normal state of mind.
[ii] https://www.ronjohnson.senate.gov/services/files/EEB419B9-934A-4154-9DED-079FC9FF72A2 . The letter claims the actual cost will be closer to $5 trillion (the number 5 followed by twelve zeros).
The House is scheduled to vote on the budget resolution next week.
[iv] See, for example, https://www.rivkinradler.com/publications/tax-increases-in-sight-time-to-sell-the-business-focus-on-economics/ .
[v] I hope “sensitive” readers will forgive my use of such an insensitive word as “moderate.”
[vi] House Democrats can’t afford to lose more than three votes from their Party if they are to pass these bills.
[vii] Apparently because Ms. Pelosi and the progressives do not trust the moderate Democrats in the Senate, especially Senators Manchin and Sinema, to support their agenda otherwise.
[viii] https://thehill.com/homenews/house/567831-moderates-revolt-on-infrastructure-in-new-challenge-for-pelosi .
[ix] https://www.pwc.com/us/en/services/deals/industry-insights.html .
[x] https://www.abajournal.com/magazine/article/anticipating-a-post-covid-19-boom-law-firms-are-staffing-upon-bankruptcy-lawyers .
[xi] Did you notice the lower case “c”?
If you’ve watched bankruptcy folks at work, you know that their “code” is more like a set of guidelines than actual rules, to paraphrase Captain Barbossa from the first Pirates of the Caribbean movie.
[xii] https://www.uscourts.gov/news/2021/01/28/annual-bankruptcy-filings-fall-297-percent .
[xiii] https://www.uscourts.gov/news/2021/05/03/new-bankruptcy-filings-plummet-381-percent .
[xiv] MIT’s Sloan School: https://mitsloan.mit.edu/ideas-made-to-matter/coming-wave-covid-19-bankruptcies-and-how-to-mitigate-them . The authors credit the Cares Act and the Paycheck Protection Program, among other measures, for having kept businesses out of bankruptcy.
[xv] I never understood why being out of the woods meant that one is no longer in danger or difficulty. I’m guessing the phrase is derived from the New England Puritans and their belief that “evil” resided in the forests. Remember the symbolism in Hawthorne’s Scarlet Letter?
[xvi] The Delta variant of the coronavirus, domestic unrest, challenges from foreign dictatorships, the undefined role and seemingly unfettered influence of technology and of those who control it – I wonder what Nostradamus foresaw for us.
[xvii] Jalbert v. McClelland (In re F-Squared Inv. Mgmt. LLC), No. 15-11469 (Bankr. D. Del. Aug. 10, 2021).
[xviii] It is my understanding that many debtors will seek to liquidate under Chapter 11 because it enables their management team to remain in place and to “control” the liquidation process. Of course, a filing under Chapter 11 suspends all foreclosure actions.
[xix] A “tax partnership.” IRC Sec. 761; Reg. Sec. 301.7701-3.
[xx] It is not clear whether this change in tax status was accomplished by an incorporation or merger, or by checking the box under Reg. Sec. 301.7701-3.
[xxi] For example, a partnership, an S corporation, an LLC treated as a tax partnership, or a disregarded entity (for example, a single-member LLC).
[xxii] It is unclear whether Debtor actually converted into a tax partnership – which would have been treated as a taxable liquidation of Debtor qua C-corporation – or whether Debtor elected to be treated as an S-corporation. IRC Sec. 1361 and Sec. 1362.
[xxiii] Because Debtor would have had to pay income taxes itself had it not elected PTE status, query whether the Court could say that either Debtor or its creditors were made worse off by Debtor’s reimbursement to its owners for their portion of the income taxes paid.
[xxiv] The owners also contended that Debtor’s obligation under the agreement to pay the Tax Distributions (regardless of the bargained for inclusion of the relevant provision) amounted to an “antecedent debt” and therefore the Tax Distributions were for reasonably equivalent value as a matter of law. Under the bankruptcy code, they argued, “debt” means “liability on a claim,” and “claim” means “right to payment, whether or not such right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured, or unsecured.” The terms “debt” and “claim” are therefore coextensive under the code. Further, under State law, an agreement like the one described above is a contract binding on the entity and “at the time a member becomes entitled to receive a distribution, the member has the status of, and is entitled to all remedies available to, a creditor of a limited liability company with respect to the distribution.” Therefore, once an owner becomes entitled to a distribution, such unpaid distribution constitutes antecedent debt.
The Court hesitated to adopt a categorical rule regarding whether any type of mandatory distribution – especially a pure profits distribution – could be a payment on an antecedent debt. Thus, the Court chose not to address this argument.
[xxv] For more on this issue, see my articles on the internet:
“Revoking S Corp. Status: A Fraudulent Conveyance?” https://www.taxlawforchb.com/2017/12/revoking-s-corp-status-a-fraudulent-conveyance/; and
“Checking the Box” – For a Pass-through Entity in Bankruptcy? https://www.taxlawforchb.com/2019/06/checking-the-box-for-a-pass-through-entity-in-bankruptcy/.