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Delaware Bankruptcy Court Determines Debtor’s QSub Status to Be Property of the Bankruptcy Estate, Protected by the Automatic Stay and Section 549 Avoidance Powers

March 2012

In In re The Majestic Star Casino, LLC, --- B.R. ---, 2012 WL 204088 (Bankr. D. Del., Jan. 24, 2012), the bankruptcy court held that the revocation by a nondebtor parent of its S-corporation status is an avoidable postpetition transfer of a debtor’s property and a violation of the automatic stay when such action automatically revokes its debtor subsidiary’s S-corporation status. 

S Corporation / QSub Status – In General

Under the Internal Revenue Code, an S corporation is generally treated as a “pass through entity” for income tax purposes.  As such, it receives no income benefits and pays no income taxes.  Instead, the S corporation’s shareholders report this income on their own personal tax returns.  An S corporation that wholly owns a subsidiary corporation may elect to treat the subsidiary as a qualified Subchapter S subsidiary (“QSub”) so that its tax benefits and burdens pass through to the parent.  If the parent S corporation ceases to be an S corporation, the QSub automatically becomes a taxable C corporation.

The Majestic Star Case

The Majestic Star Casino, II (the “Debtor Subsidiary”) and its affiliated debtors owned and operated casino properties.  Before the Debtor Subsidiary filed for bankruptcy, its nondebtor parent (“Nondebtor Parent”) operated as an S corporation and elected to classify its wholly owned Debtor Subsidiary as a QSub.  After the Debtor Subsidiary filed for chapter 11, the Nondebtor Parent filed a notice revoking its status as an S corporation (“S-Corp Revocation”).  The S-Corp Revocation by the Nondebtor Parent had the automatic effect of terminating the Debtor Subsidiary’s status as a QSub.  As taxable C corporations, the Nondebtor Parent and Debtor Subsidiary were each required to file tax returns and pay income taxes.  The change in corporate status of the Debtor Subsidiary meant that it could be subject to income tax liability on account of its operations, which liability had previously passed through to the Nondebtor Parent.  Neither the Nondebtor Parent nor its shareholder (the “Owner”) sought bankruptcy court authority for the S-Corp Revocation. 

In response, the Debtor Subsidiary filed suit against the Nondebtor Parent and the Owner seeking to avoid the S-Corp Revocation as an unauthorized postpetition transfer of estate property and a violation of the automatic stay.  The Nondebtor Parent and Owner argued that the Debtor Subsidiary’s QSub status was not property of the estate and not subject to the automatic stay because such status was wholly dependent upon the independent actions of the Nondebtor Parent through the Owner.  The bankruptcy court disagreed.  After the Debtor Subsidiary commenced its bankruptcy case, it elected to sell its assets rather than attempting to reorganize.  The bankruptcy court recognized that if the sale was successful, the proceeds would be subject to taxes that would have previously passed through to the Nondebtor Parent (and then to the Owner) as a result of their respective QSub and S corporation status. 

In rejecting the arguments of the Nondebtor Parent and Owner, the bankruptcy court relied on the well established line of case law that broadly interprets the Bankruptcy Code’s definition of “property of the estate” to include intangible assets such as tax reporting status.  The bankruptcy court noted that the Nondebtor Parent’s election to treat the Debtor Subsidiary as a QSub had conferred significant tax benefits upon the Nondebtor Parent when losses were being passed through prior to bankruptcy.  If the bankruptcy court did not avoid the S-Corp Revocation, the Debtor Subsidiary would be stuck with the burden of reportable income in any bankruptcy asset sale, thereby diminishing the amount of funds available to pay the claims of creditors.  In the end, the bankruptcy court held that the Debtor Subsidiary had a direct and important interest in its tax status even if that status was dependent upon a pre bankruptcy election by the Nondebtor Parent. 

Having found that Debtor Subsidiary’s status as a QSub was property of the bankruptcy estate, the bankruptcy court made straightforward applications of sections 549 (unauthorized postpetition transfers) and 362 (violation of the automatic stay) of the Bankruptcy Code.  The bankruptcy court held that the S-Corp Revocation “caused a [postpetition and unauthorized] transfer of property from the bankruptcy estate” for purposes of section 549.  Likewise, the court found that any postpetition action that caused the Debtor Subsidiary to lose its QSub status was an act to exercise control over property of the estate in violation of the automatic stay.  The Parent, Owner, the IRS, and the state department of revenue were directed to take all actions necessary to restore the Debtor Subsidiary’s QSub status and the state department of revenue was ordered to return all tax monies paid as a result of the unauthorized S-Corp Revocation.

Arguably, this decision handcuffs parent corporations and shareholders by preventing them from shifting tax benefits and burdens after the petition date without court authorization — actions that would normally constitute legitimate tax planning actions outside of the bankruptcy context.  Moreover, by recognizing tax status as an asset of the estate, the bankruptcy court’s decision will also call into question prepetition revocations where the subsidiary is insolvent because no consideration or other benefit is given in exchange for the revocation.  This means that the revocation of a subsidiary’s tax status is not only restricted postpetition but could be challenged during the bankruptcy case for any transfers that occurred up to six years before the petition date.  The decision also leaves open the question whether corporate debtors and other courts will attempt to springboard off the bankruptcy court’s basic reasoning to prohibit non-debtor actions that are farther removed from a debtor’s economic interests.  In the end, this decision shows why pre bankruptcy tax planning is so important and subject to potential avoidance if the subject debtor is insolvent at the time of the revocation.