The Congressional Budget Office (“CBO”) recently released some data for the federal government’s 2023 fiscal year. According to the CBO, the federal budget deficit for the year was $1.7 trillion, or 28-percent larger than it was in 2022.[i]
The CBOs’ report attributed the increase to a combination of lower revenues and higher outlays. Can you guess which expenditure was among those most responsible for the increase? If you said payments of interest on the federal debt, you were right.
About a month earlier, the Wall Street Journal reported that bank lending to businesses was expanding very slowly, due in no small part to higher interest rates and lenders’ more cautious approach to extending credit.
About a month before that, the Federal Reserve noted a decline in the U.S. money supply, which some observers attributed to increased reserves held by banks, and to the increased use of credit and debit cards.[ii] In fact, consumers have continued to spend,[iii] with the result that credit card debt now sits at more than $1.2 trillion.[iv]
What does it all mean?
Unfortunately, the answer depends upon whom you ask. Seriously. Economists may be as bad as many lawyers in that regard. Or even scientists these days.[v]
My visceral reaction: it can’t be good. For instance, business bankruptcy filings rose more than 23-percent in the year ending June 30, 2023.[vi] At that rate, the veil that separates the rarefied world of the tax law from the gritty streets of bankruptcy practice will often part to allow the beings from each to interact with one another, sometimes with unexpected results, as illustrated by a recent decision of the Bankruptcy Court.[vii]
An S Corporation
Taxpayer incorporated Debtor and was its sole shareholder, director and officer from the time of its organization to the events in question. As its sole officer and director, Taxpayer elected, and as its sole shareholder, consented, that the corporation be treated as an S corporation.
As a result the election, and in accordance with Subchapter S of the Code,[viii] Debtor “avoided tax liability”[ix] by passing its income, losses, deductions, and credits to Taxpayer[x] – who reported these items on Taxpayer’s own individual income tax return – while Taxpayer was able to “avoid double taxation” on all distributions from Debtor.[xi]
Many years after its organization, “significant judgments” were entered against Debtor. As a result, Debtor appointed Officer as its Chief Transformation Officer (CTO) and, shortly thereafter, filed a petition under Chapter 11 with the Bankruptcy Court. Among other things, the filing operated as a stay of “any act to obtain possession of property” of the debtor-corporation.[xii]
Not long after filing its petition, Debtor reconstituted its board of directors to add a majority of independent directors. This board removed Taxpayer as an officer and director, which left Officer to operate Debtor as both its CTO and acting CEO.
In order to raise funds pay off its debts, Debtor sought and obtained approval to conduct a competitive sale and auction process. Eventually, Debtor contracted to sell its assets to unrelated Buyer.
The sale price was $370 million, $362 million of which was to be paid in cash at closing. After satisfying the secured debt, however, the sale was expected to generate only $11.6 million in proceeds for Debtor’s unsecured creditors, and nothing for its shareholder, Taxpayer.
Because Debtor was an S corporation, all the taxable gain and other income arising from the sale of Debtor’s assets would flow through to Taxpayer, making Taxpayer liable for the resulting income taxes notwithstanding that Taxpayer would never receive any of the sale proceeds.[xiii]
Taxpayer decided that the only way to avoid this outcome was to revoke or otherwise terminate Debtor’s S election, thereby converting Debtor into a taxable C corporation.
By doing so, Debtor would become subject to corporate-level income tax in respect of the gain from the sale,[xiv] and Taxpayer would no longer be required to report the corporation’s gain on Taxpayer’s income tax return.
However, this gambit presented an issue because, although Taxpayer was Debtor’s sole shareholder, Taxpayer no longer had any managerial authority with respect to the corporation.
In fact, Debtor’s board met regarding Taxpayer’s desire to have Debtor revoke its S election, though after considering the potential tax consequences, the board rejected the idea.
In light of the foregoing, and only three weeks before the asset sale was scheduled to close, Taxpayer filed a motion asking the Court to determine that Debtor’s S election was not property of the estate and that the automatic stay did not bar Taxpayer from revoking it.[xv]
Predictably, Debtor and the Official Committee of Unsecured Creditors (the “Committee”) objected to Taxpayer’s motion. They asserted that the S election was property of Debtor’s estate and, thus, protected by the automatic stay which prohibited any person from taking possession of Debtor’s property.
Debtor and the Committee also argued there was “no cause” to lift the stay[xvi] because if the stay were lifted and Debtor’s S election were revoked, the corporate income tax liability Debtor would incur on the asset sale would eliminate the expected $11.6 million payment to the unsecured creditors and render the estate administratively insolvent.
The Court conducted a hearing at which the parties’ respective experts testified regarding the potential tax implications of the proposed sale.[xvii]
Allocation of Gain
The experts agreed that if Debtor’s S election were revoked, its tax year would be divided into two years – an “S Short Year” (the portion of the year before the S election was revoked) and a “C Short Year” (the period of the year after the S election was revoked) – and the corporation’s income and expenses would then be allocated between the two Short Years in one of two ways.
Under the Code’s default rule,[xviii] referred to as the “pro rata allocation” method, income and expenses would be allocated pro rata between the S Short Year and C Short Year based on how many days out of the year the corporation was an S corporation and how many it was a C corporation.[xix] The shareholder would then pay the taxes due for the S Short Year, while the corporation would pay the taxes due for the C Short Year.[xx]
Under the second method, referred to as the “close the books” approach, the corporation’s books would be closed as of the end of the day before the S election was revoked.[xxi] Any income and losses before the corporation’s books were closed would be allocated to the S Short Year; any income and expenses accruing after its books were closed – including, in this case, the gain from the asset sale – would be allocated to the C Short Year.[xxii]
The Court’s Decision
At the conclusion of the hearing, the parties requested that the Court rule on the motion before the sale, which was set to close only three days later.
The Court issued its ruling the next day, and entered an order denying Taxpayer’s motion because the Court found that Debtor controlled the S election and Taxpayer could not compel Debtor to revoke it, nor could Taxpayer compel Debtor to “close the books,” thus rendering the relief requested impossible to provide.
Therefore, according to the Court, there was no need to decide whether the S election was property of the estate,[xxiii] although the Court reserved jurisdiction to do so.
Taxpayer, however, requested that the Court rule on this issue because Taxpayer was considering transferring their stock in Debtor in a way that would cause Debtor to become ineligible to be an S corporation and therefore result in its S election being terminated.[xxiv]
Property of the Estate
The Bankruptcy code[xxv] provides that property of a debtor’s estate includes “all legal or equitable interests of the debtor in property as of the commencement of the case,” wherever located and by whomever held.[xxvi] According to the Court, in defining “property of the estate” in that way, Congress intended for the term to have the broadest possible meaning.[xxvii]
Obvious examples of property that courts have found fall within this provision include tangible assets such as real property, vehicles, equipment, and inventory.
Of course, courts have also found property of the estate to include intangible assets. Obvious examples include causes of action and intellectual property rights. Perhaps less obvious examples include a company’s goodwill and a government-issued license.[xxviii]
The Court then explained that tax attributes that reduce a debtor-corporation’s tax liability are also property of the estate. After conceding it was “impossible to give any categorical definition to the word ‘property,'” the Court noted that courts generally have construed the term “property” very generously. Indeed, the Court stated that the main limitation on whether an interest was “property” for purposes of the Bankruptcy code was whether treating it as such would impede a debtor’s “fresh start.”
The Court recognized, for example, that a number of courts have held that a debtor’s tax attributes, such as net operating loss (“NOL”) carryforwards were property of the debtor’s estate.
It also pointed out that a number of courts have held that a corporation’s election to be treated as an S corporation is also property of the estate, stating that a debtor “possessed a property interest – i.e. a guaranteed right to use, enjoy and dispose of that interest – in its Subchapter S status.”[xxix]
Taxpayer, however, relying on a decision of the Third Circuit Court of Appeals,[xxx] argued that an S election is not property of the debtor-corporation’s estate, in which case it may be “removed” from the estate – i.e., revoked.
Taxpayer’s Position – Third Circuit
The Third Circuit case involved a debtor-corporation that was a qualified subchapter S subsidiary (“QSub”). After the debtor filed for bankruptcy, its parent S corporation revoked its own S election, which caused its debtor-subsidiary to lose its QSub status. Consequently, and in accordance with Subchapter S of the Code, the cancellation of indebtedness income[xxxi] that would otherwise have passed through the QSub to its parent and then to the parent’s individual shareholder was captured, instead, at the level of the debtor-subsidiary.
The debtor-subsidiary then filed an adversary proceeding seeking to undo the revocation of the election, alleging that the revocation was “an unlawful post-petition transfer of property” that violated the automatic stay and which should be avoided under the Bankruptcy code.[xxxii]
On summary judgment, the Bankruptcy Court ruled that the debtor’s QSub status was property of the estate and that the parent’s indirect revocation of such status was void. The parent corporation appealed to the Third Circuit.[xxxiii]
Before deciding that a debtor’s S election was not “property” of the estate – and thereby upholding the revocation of the debtor-corporation’s S election – the Third Circuit examined earlier cases which had concluded that a debtor-corporation’s S election was such property. The Third Circuit determined these cases had improperly “equated” the nature of one debtor-corporation’s S election with the nature of another’s NOL carryforwards.
According to the Third Circuit, these earlier cases failed to consider some important differences between the two tax attributes. Specifically, it stated that the value of an NOL carryforward was “readily determinable” as opposed to the value of an S election; likewise, it stated that the S corporation’s shareholders may revoke its election, whereas they could not limit a corporation’s right to deduct its NOL carryforwards.
The Court’s Response
The Bankruptcy Court found that the Third Circuit’s reasoning was faulty.
The Court pointed out that an S election shifts tax liability from the electing corporation to its shareholders. The value of that corporate-level tax savings is as readily determinable, the Court asserted, and is as immediately available to the corporation, as are the tax savings from an NOL carryforward.
In addition, the Court explained that shareholders cannot revoke an S election, as assumed by the Circuit. Instead, it is only the corporation that can revoke its S election, though it cannot do so without the consent of the majority of its shareholders.[xxxiv]
While it is true, the Court acknowledged, that shareholders of an S corporation can take actions that result in termination of the corporation’s S status – for example, by selling shares to an ineligible shareholder, like a partnership or a foreign citizen[xxxv] – a corporation’s shareholders can also unilaterally take action that results in limiting the corporation’s right to deduct its NOLs, as when a shareholder who owns five percent of a corporation increases their ownership by more than 50-percent, triggering an “ownership change.”[xxxvi]
However, the fact that a shareholder can take action that results in the termination of a corporation’s S status, the Court continued, is irrelevant to whether the S election is property of the estate. After all, the Bankruptcy codedoes not, by its express terms, limit property of the estate in any way to property interests that are noncontingent.[xxxvii] An interest is property of the estate, the Court explained, even if it is contingent; the term “property” must be construed generously – an interest is “not outside its reach because it is novel or contingent or because enjoyment must be postponed.”
The Court’s Conclusion
This Court ended its “property of the estate” analysis where it started: the text of that provision of the Bankruptcy code[xxxviii] which provides that the term “property” includes “all legal or equitable interests of the debtor in property as of the commencement of the case.” Although this provision does not define “property,” the Court stated that its legislative history makes clear that the scope of the provision is broad, and that “it includes all kinds of property, including tangible or intangible property.”
The Court acknowledged that a corporation’s right to its S election is contingent on a shareholder not taking action that could cause the corporation to cease being a small business, thereby terminating the S election. It may also be true, the Court conceded, that a debtor corporation cannot transfer an S election. The Bankruptcy code, however, says nothing about property having to be noncontingent or transferrable to qualify as property of the estate. Thus, the Court declined to read into the code[xxxix] “limitations that do not exist in the text.”
Absent the S election, the corporation’s profits are taxed at the corporate rate[xl] and the shareholders are taxed on corporate distributions at their respective income tax rates,[xli] thus incurring double taxation. The Code gives small businesses, such as Debtor, the right to elect to be an S corporation, and to avoid this double taxation by paying no tax itself and passing its income, along with any losses, deductions, and credits, to the corporation’s shareholders, leaving only the shareholders to be taxed.[xlii] Once a qualifying corporation elects to be treated as an S corporation, it retains that status until terminated or revoked.[xliii] Until terminated or revoked, then, an S corporation has the valuable right of not having to pay taxes.
There is no basis, the Court stated, to suggest that the statutory right to avoid an expense, including taxes, is any less a property right than property that produces income. In other words, a corporation has a property interest “in its right to avoid the tax expense otherwise known as the S election.” Debtor had a property interest in its S status because, once elected, that status gave Debtor the right to avoid paying taxes.
Thus, Debtor’s S election was property of the estate, and the automatic stay barred Taxpayer from attempting to revoke it.[xliv]
Did the Court get it right? I don’t think so.
It’s true that the S election conferred value to Debtor and its creditors, but did it create a property right in the corporation within the meaning of the Bankruptcy code?
The Court made much of the fact that a corporation makes or revokes the S election, not its shareholders. Most of the time, the distinction between the corporation and its shareholders is irrelevant because, typically, the shareholders of a closely held S corporation are also the corporation’s officers and directors. Thus, when they decide to revoke their corporation’s S election, they are doing so wearing their multiple hats (shareholder, officer and director).
However, that fact alone does not indicate that the corporation plays no role in the decision to revoke an election. In the present case, for instance, Debtor’s officers and directors were not identical to its shareholder (Taxpayer) – in other words, neither their interests nor their fiduciary duties were aligned, as reflected by Debtor’s officers and directors having concluded it would not be in the best interests of the corporation’s bankruptcy estate to revoke the S election because doing so would divert sale proceeds to the payment of a corporate tax liability, thereby depriving the unsecured creditors of the proceeds that had been allocated to pay them.
Still, it does not make sense to treat Debtor’s S election as property of the bankruptcy estate where Taxpayer had the power under the Code to legally revoke or otherwise terminate the election at any time before the Chapter 11 filing.
What’s more, the Court’s conclusion should not depend upon whether Taxpayer was replaced with a new set of officers and directors, thereby creating the divergent interests described above. The property right either belonged to Debtor or it didn’t.
It is more likely that the Court’s decision was based upon its finding that Taxpayer was not acting equitably or fairly.[xlv] The Court made much of the fact that Taxpayer had, for many years, enjoyed the benefits of Debtor’s S election, having avoided the double taxation to which C corporations and their shareholders are subjected. Once Debtor was in bankruptcy, however, Taxpayer sought to avoid the burdens of that S election and to foist the income tax liability resulting from the asset sale onto Debtor, to the detriment of the unsecured creditors.[xlvi]
Assuming there is some legal basis on which to support this position, will the shareholder necessarily be harmed by the continuation of the corporation’s S election and the inclusion of the gain from the asset sale on the shareholder’s tax return?
A financially distressed S corporation has likely generated substantial losses, having gone through not only its shareholders’ capital contributions and its undistributed income, but also the funds borrowed from third parties or from the shareholders. Some of these losses may have been “suspended,” and remain unused by the shareholders, because the shareholders have exhausted their basis for their shares of stock and for their loans to the corporation.[xlvii]
The flow-through of gain to the shareholders would increase their debt and stock bases (in that order),[xlviii] thereby allowing them to utilize some, though perhaps not all, of their suspended losses.[xlix]
As always, it is imperative that all parties to a transaction involving a distressed business consult with their respective tax advisers as early in the process as possible. Forewarned . . .
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[iii] I’m certain many of them have resumed payments on student loans. Life’s a bitch, isn’t it? Get over it.
[v] The media is in a class of its own. I suspect the media has its own place in Dante’s Inferno – perhaps Satan is standing on the media’s shoulders in the ninth circle.
In the movie, Meet Joe Black, the character of William Parrish speaks about the newspaper he founded: “I’d hoped to create something, something which could be held to the highest standards. And what I realized was I wanted to give the news to the world, and I wanted to give it unvarnished. The more we all know about each other, the greater the chance we will survive. . . Reporting the news is a privilege and a responsibility, and it is not exploitable.”
[vii] In re: Vital Pharmaceuticals, et al., Debtors, United States Bankruptcy Court for the Southern District of Florida, Fort Lauderdale Division (decided October 6, 2023).
[viii] I should point out that a capital “C” is reserved for the Internal Revenue Code. Lesser coda, like the Bankruptcy code, . . ., well, enough said.
[ix] The Court’s choice of words. Talk about telegraphing the conclusion.
[x] Reflected on the Sch. K-1 issued by Debtor to Taxpayer.
It is not clear from the Court’s opinion whether the corporation made “tax distributions” to its shareholder.
[xi] Under IRC Sec. 1366, every shareholder of an S corporation is required to report their pro rata share of the corporation’s items of income, loss, etc. on their individual income tax return for purposes of determining their income tax liability.
The S corporation itself is not taxable. IRC Sec. 1363(a).
In general, when the S corporation distributes to its shareholders the corporate earnings on which they have already been taxed, the distribution is not taxable a second time. IRC Sec. 1367 and 1368.
By contrast, a C corporation pays tax on its taxable income and, when it makes a dividend distribution of the remaining earning to its shareholders, the latter report such distributions as income on their own returns.
[xii] Under Sec 362 of the Bankruptcy code.
[xiii] IRC Sec. 1366.
Under the “absolute priority” rule, the owners of a debtor will not receive or retain under the bankruptcy plan any property in respect of their equity interest unless all general unsecured claims are paid in full. 11 USC 1129(b).
[xiv] To ensure that this gain was reported only on Debtor’s tax return, Taxpayer also sought to “close” Debtor’s books following the loss of the S election, thereby capturing the gain entirely within the C corporation’s short tax year. More on this in a bit.
[xv] Alternatively, if the Court concluded Debtor’s S election was property of the estate and that the automatic stay applied, Taxpayer asked that the Court grant Taxpayer relief from the stay to revoke the election. The Court considered and rejected Taxpayer’s alternate position.
[xvi] 11 USC 362(d) provides that, on request of a party in interest and after notice and a hearing, the court shall grant relief from the stay by terminating, annulling, modifying, or conditioning such stay for cause, including the lack of adequate protection of an interest in property of such party in interest.
Beyond saying it includes “lack of adequate protection,” Sec. 362(d)(1) does not define “cause.” Courts considering whether “cause” exists under Sec. 362(d)(1) , however, have concluded that it “exist[s] when the harm that would result from a continuation of the stay would outweigh any harm that might be suffered by the debtor or the debtor’s estate if the stay is lifted.” When balancing those potential harms, courts consider a number of factors, including (i) the harm to the party seeking relief from the stay if the stay is not lifted; (ii) the harm to the debtor if the stay is lifted; (iii) the interests of creditors; and (iv) the effect on the fair and efficient administration of justice.
[xvii] The experts disagreed about the extent of the parties’ potential tax liability if the S election was not revoked. According to Debtor’s expert, if Debtor retained its S election, Taxpayer would owe tax on the sale of Debtor’s assets, but would also receive a large amount of net capital loss carry-forwards and net operating loss carryforwards, which could reduce his future tax liability by a significant amount. If Debtor’s S election were revoked, however, and the corporation elected to “close the books,” Taxpayer would incur no tax liability, and the estate would have a substantial tax liability.
Taxpayer’s expert painted a far more dire tax impact from the sale, opining that Taxpayer’s tax liability would be many times greater than the amount determined by Debtor’s expert.
[xviii] Under IRC Sec. 1362(e)(2).
[xix] IRC Sec. 1362(e)(2). For example, if Vital’s S election was revoked on August 1, then 7/12th of its income and expenses would be allocated to the “S Short Year,” and 5/12th of its income and expenses would be allocated to the “C Short Year.”
[xx] IRC Sec. 1362(e)(2).
[xxi] IRC Sec. 1362(e)(3)(A).
[xxii] IRC Sec. 1362(e)(3)(A).
[xxiii] Or whether the stay applied, or whether relief from the stay should be granted.
[xxiv] For example, a transfer to a partnership or to a foreign person, neither of which is eligible to hold shares of stock in an S corporation.
[xxv] Sec. 541(a).
[xxvi] 11 U.S.C. Sec. 541.
[xxvii] “The scope of [§ 541(a)(1) ] is broad. It includes all kinds of property, including tangible or intangible property, causes of action (see Bankruptcy Act § 70a(6)), and all other forms of property currently specified in section 70a of the Bankruptcy Act.” H.R. Rep. No. 95-595 , at 367 (1977); S. Rep. No. 95-989 , at 82 (1978).
[xxviii] The Court observed that it was important to distinguish what may be an “asset” of the debtor from its property.
“Property,” the Court continued, has a much broader meaning than “asset.” For example, real property that has substantial environmental contamination and no value may, in fact, be a liability and therefore may not be considered an asset. Yet, it is still “property.” That is why a trustee has the right – and is required – to abandon such property so the bankruptcy estate may avoid the liability. So, the term property should not be confused with asset.
[xxix] The seminal case is In re Trans-Line West, where the Court ruled that the revocation of a debtor’s S election was a “transfer of an interest of the debtor in property” under Bankruptcy code Sec. 548. Trans-Line West, 203 B.R. at 662.
[xxx] In re Majestic Star Casino, 716 F.3d 736 (3d Cir, 2013).
[xxxi] IRC Sec. 61(a)(11).
[xxxii] Sections 362 and 549.
In general, a motion to avoid such a transfer may not be commenced after the second anniversary of the transfer in question.
[xxxiii] That ruling was significant. Confirmation was going to result in a substantial amount of “cancellation of debt” (“COD”) income. If revocation of the debtor’s QSub status was void, then the parent corporation’s shareholders would be liable for the taxes on the COD income. And because the debtor was not liable, it could retain tax attributes (deductions and credits) that would allow it to reduce its taxes in the future.
Had the debtor been liable for the COD income, it could have availed itself of the so-called “bankruptcy exception,” which allows a taxpayer in bankruptcy to avoid taxes on debt that is canceled or written down under a confirmed plan. (IRC Sec. 108(a)(1)(A) ). But if the debtor availed itself of the “Bankruptcy Exception,” it would have to reduce the value of its other tax attributes dollar-for-dollar.
[xxxiv] Under Reg. Sec. 1.1362-6(a)(3), “[t]o revoke an election, the corporation files a statement that the corporation revokes the election.”
However, the “revocation may be made only with the consent of shareholders who, at the time the revocation is made, hold more than one-half of the number of issued and outstanding shares of stock (including nonvoting stock) of the corporation.”
The same theme appears in the S election, under Reg. Sec. 1.1362-6(a)(2): “Internal Revenue Code § 1362 provides that a “small business corporation may elect . . . to be an S corporation.” IRC Sec. 1362(a)(1). An election is valid “only if all persons who are shareholders in such corporation on the day on which such election is made consent to such election.” IRC Sec. 1362(a)(2). Reg. Sec. 1.1362-6 then prescribes the manner of making that initial election: “A small business corporation makes an election under section 1362(a) to be an S corporation by filing a completed Form 2553,” though the election is not valid unless all shareholders give their consent.
[xxxv] IRC Sec. 1362(d)(2) ; see alsoIRC Sec. 1361(b)(1).
[xxxvi] Under IRC Sec. 382.
[xxxvii] 11 U.S.C. Sec. 541(a)(1) (defining property of the estate to include “[e]xcept as provided in subsections (b) and (c)(2) of this section, all legal or equitable interests of the debtor in property as of the commencement of the case”).
[xxxviii] Section 541.
[xxxix] Again: Bankruptcy code is spelled with a lower case “c” whereas Internal Revenue Code is spelled with an upper case “C”.
[xl] IRC Sec. 11 (21-percent).
[xli] IRC Sec. 1(h) (20-percent) and IRC Serc. 1411 (3.8-percent).
[xlii] IRC Sec. 1362(a)(1).
[xliii] IRC Sec. 1362(d) provides that a corporation’s S election shall be terminated if (1) the corporation ceases to be a “small business corporation,” which is defined as a domestic corporation that does not have more than 100 shareholders; have a shareholder (other than certain trusts) who is not an individual; have a nonresident alien as a shareholder; and have more than one class of stock; or (2) the corporation’s passive income exceeds 25% of gross receipts for three consecutive taxable years and the corporation has accumulated earnings and profits.
[xliv] On the request of a party, however, the Court may grant relief from the automatic stay “for cause.” Here, Taxpayer failed to demonstrate “cause” entitling him to stay relief.
[xlv] Hogs get slaughtered.
[xlvi] “It is inconceivable,” the Court stated, that [Debtor], as [Taxpayer] contends, would have no say in the matter.” Because Debtor’s S election gave it the valued right to avoid tax liability, the S election is property of the estate and therefore protected by the automatic stay.
[xlvii] IRC Sec. 1366(d).
[xlviii] IRC Sec. 1367.
[xlix] It is also possible that the gain will exceed the available losses, thus resulting in a net cash outlay by the shareholders for taxes owing.