- Nos. 12-3200/3201 (3d Cir., May 21, 2013)
- Debtor lacked standing to challenge non-debtor parent/shareholder's revocation of election of S Corp status. Rejecting cases from other circuits, the Third Circuit found that S Corp status is not a property interest. Alternatively, even if S Corp status were a property interest, S Corp status is not an interest of the debtor entity because the right to revoke S Corp status belongs to the shareholder parent. The Debtors' challenge to termination of S Corp status was premised on the concept that it had a vested property interest in maintaining S Corp status. As a preliminary matter, the Third Circuit determined that the issue was controlled solely by the Internal Revenue Code, rather than state law. Evaluating a line of cases which found that S Corp status was a property interest, the Third Circuit noted that those cases - the "Trans-Lines West cases" - were premised on a series of cases which determined that Net Operating Losses were "an interest in property." The Court, dubious that even the NOL cases were correctly decided, distinguished S Corp elections for several reasons, including that the IRC "does not, and cannot, guarantee a corporation's right to S-corp status, because the corporation's shareholders may elect to revoke that status 'at will.'" As an alternative ground, the Court found that even if S Corp status were a property interest, that interest belongs to the non-debtor parent. To construe the interest as a right of the debtor entity bearing the S Corp status would place "remarkable restrictions" on the non-debtor parent that have no foundation in the Internal Revenue Code or the Bankruptcy Code (such as restrictions on transfers by the non-debtor that would void the debtor's S Corp status). For this and other reasons, the Court found that the debtor/estate had no property right with respect to the S Corp status/election. Based on these determinations, the Debtors lacked standing to bring the adversary complaint challenging the non-debtor's decision to terminate the Debtors' S Corp status, and accordingly the bankruptcy court's judgment was vacated, with directions to dismiss the adversary proceeding.
- Procedural context:
- Direct appeal from bankruptcy court, which had granted Debtors' motion for summary judgment ordering non-debtor and IRS to reinstate Debtors' S Corp status. Judgment of bankruptcy court vacated with directions to dismiss adversary proceeding.
- Pre-bankruptcy, individual had elected to treat Casino-owning entities as S Corps. The result of this election to impose S Corp status was that the taxable earnings of the S Corp entities were not taxed at the entity level. Instead, taxable earnings were passed through to the non-debtor owner/shareholder. After petition date, non-debtor owner/shareholder revoked prior election to treat debtor entities as S Corporations. Termination of S Corp status meant that the Debtors would thereafter be subject to taxation, and in this case, that meant that $2.26 million of estimated tax would be owed by the Debtors. Alternatively, if the Debtors were correct that the non-debtor could not terminate their S Corp status, the non-debtor would face $170 million in Cancellation of Indebtedness income (COD exemption for indebtedness cancelled under Bankruptcy Code is only applicable to debtors), and remain subject to paying the Debtors' tax liability so long as that status was retained, even though the non-debtor no longer received any distribution of income earned by the Debtors.
- Ambro, Jordan, and Vanaskie
3311 in the system
1 Being Processed