Taking sides with a Third Circuit decision from 2013, Bankruptcy Judge Kevin R. Huennekens of Richmond, Va., decided that status as a so-called S corporation is not a debtor’s property under Section 541. Because S status is not property, the shareholders’ decision to change the debtor’s status to a C corporation cannot provide the foundation for a fraudulent transfer suit under Sections 544 or 458.
In his opinion on Dec. 6, Judge Huennekens disagreed with five decisions from lower courts that concluded that S status was property. Those decisions included opinions from the Eighth and Ninth Circuit Bankruptcy Appellate Panels. All five predated the Third Circuit’s opinion in Majestic Star Casino LLC v. Barden Development Inc. (In re Majestic Star Casino LLC), 716 F.3d 736 (3d Cir. 2013).
Majestic Star was persuasively written by Circuit Judge Kent A. Jordan, who concluded that the S corporate tax status of a non-bankrupt parent was not property of a bankrupt subsidiary. Judge Jordan said that whether tax status is “property” is a question of federal tax law, not state law.
The lower courts’ conclusions that S status was property emanated from Segal v. Rochelle, U.S. 375 (1966), where the Supreme Court ruled that a tax-loss carryback is property of a bankrupt estate. In 1991, the Second Circuit expanded the Segal doctrine to hold that tax loss carryforwards are also a bankrupt estate’s property. Later, lower courts expanded the doctrine to include S corporate status as a bankrupt’s property.
Like Judge Jordan, Judge Huennekens explained how S corporate status is different from net operating losses, because tax losses are created by events occurring before bankruptcy and are set in stone. S status, on the other hand, can be terminated at the whim of the owner.
Judge Huennekens did more than parrot Majestic Star. His analysis focused on authority from the Fourth Circuit, which has not opined on S status as a property right.
In Virginia Historic Tax Credit Fund 2001 LP v. Commissioner of Internal Revenue, 639 F.3d 129, 140 (4th Cir. 2011), the Fourth Circuit held, like the Third, that federal tax law determines whether tax attributes amount to property. In a particular case, the answer turns on six factors, laid out in Virginia Historic.
The debtor’s ability to use S status was the only factor, Judge Huennekens said, weighing in favor of property. The right to use was a weak factor, he said, because the S corporation itself has no right to control or dispose of the status, since the owners by themselves can change the company to a C corporation.
Like Judge Jordan, Judge Huennekens rejected the idea that status must be property simply because it is valuable. By analogizing to an insurance policy that has value for a beneficiary, Judge Huennekens said that “the fact that something confers value to the estate does not necessarily create a property right in it.”
Like the beneficiary of an insurance policy, “a corporation cannot claim a legal or equitable interest to a valuable benefit that another party has the power to legally revoke at any time,” Judge Huennekens said.
Dismissing the fraudulent transfer claims, Judge Huennekens said, “To the extent there is value inherent in the S election, it is value Congress intended for the corporation’s shareholders and not for the corporation.”