Deciding that the “syllogistic reasoning” of the Third Circuit was “faulty,” Bankruptcy Judge Peter D. Russin of Fort Lauderdale, Fla., instead followed several lower courts and held that a debtor’s status as a Subchapter S corporation is estate property that the owner cannot terminate in view of the automatic stay.
Even if the owner were entitled to a stay modification, Judge Russin also ruled in his October 6 opinion that the power to terminate a Subchapter S election rests in the corporation, not in the owner.
The Sale and the Resulting Tax Liability
The debtor was a corporation that elected Subchapter S status at inception in 1993. In the ensuing years, Judge Russin said that the debtor corporation “has avoided tax liability by passing its income, losses, deductions, and credits to [the owner, who] has been able to avoid double taxation on all distributions from [the debtor] for the past three decades, just as contemplated by the creators of the S corporation.”
Saddled with “significant judgments” in 2022, the debtor filed a chapter 11 petition the following month. The owner had been the sole officer and director. Replaced by a restructuring officer, the owner was removed as an officer and director after the appointment of an independent board during the chapter 11 case.
The debtor contracted to sell the assets for $370 million. Closing the sale, according to Judge Russin, would generate only $11.6 million for unsecured creditors, after dealing with secured lenders.
As Judge Russin said, “all the taxable income from the sale would flow through to [the owner], making him liable for the resulting taxes.” Consequently, the owner filed a motion for a declaration that Subchapter S status was not estate property, thus allowing him to revoke Subchapter S status in the absence of the automatic stay. Alternatively, the owner wanted Judge Russin to modify the stay.
If the Subchapter S election were revoked, the experts disagreed about the resulting tax liabilities. In the worst case, the debtor would have a $27.5 million tax liability, eliminating the distribution to unsecured creditors and rendering the estate administratively insolvent.
In the best case scenario for the debtor, the tax bill would be $9.2 million, reducing the distribution to unsecured creditors by 80%.
The experts also disagreed about the tax effects for the owner if the Sub S status were to remain. Judge Russin found the debtor’s expert to be more credible and deduced that the owner would have a $3.4 million tax bill. The debtor’s expert predicted tax liability to be between $95 million and $197 million.
Aside from the $3.4 million tax liability, Judge Russin found that the owner could carry forward $49 million in net capital losses and $23 million in net operating losses.
Estate Property or Not?
To decide whether Sub S status is or is not estate property, Judge Russin began with Section 541(a), which says that estate property is comprised of, among other things, “all legal or equitable interests of the debtor in property as of the commencement of the case.” He quoted the Collier treatise for saying that “anything not specifically excluded under [§ 541(b)] should be included as property of the estate.”
For authority, Judge Russin relied primarily on Segal v. Rochelle, 382 U.S. 375, 381 (1966), where the Supreme Court held that net operating loss carrybacks were property of the estate under Section 70(a)(5) of the former Bankruptcy Act. The Court did not consider whether loss carryforwards are estate property, Judge Russin said.
However, Judge Russin cited the Second Circuit for holding in 1991 that NOL carryforwards are also estate property.
On point, Judge Russin cited a “number of bankruptcy courts [that] have held that an S election is also property of the estate.”
Countering bankruptcy court decisions, the owner cited Majestic Star Casino, LLC v. Barden Dev., Inc. (In re The Majestic Star Casino, LLC), 716 F.3d 736 (3d Cir. 2013), where the Third Circuit held that Sub S status is not “property.” Judge Russin found Majestic Star’s “syllogistic reasoning” to be “faulty.”
Judge Russin found other faults in the Third Circuit’s analysis as well. While owners can take action that will result in the termination of a Sub S election by selling the shares to a foreigner, for example, he said “it is only the corporation that can revoke its S election, though it cannot do so without the consent of the majority of shareholders.”
For Judge Russin, whether an owner could unilaterally act to end Sub S status was “irrelevant,” because property interests in Section 541 are not limited “to property interests that are noncontingent.”
Judge Russin saw a “valued right” for the corporation in not having to pay taxes and saw “no basis” for believing that the right to avoid taxes “is any less a property right than property that produces income.”
Holding that Sub S status is property of the estate, Judge Russin ended where he began, with the broad definition of estate property in Section 541 and the Supreme Court’s statement in Segal that “the term ‘property’ has been construed most generously.”
No Stay Modification
Alternatively, the debtor wanted Judge Russin to modify the automatic stay so he could revoke Sub S status. The judge found no “cause” to lift the stay.
Judge Russin ran the numbers and concluded that the best outcome would be an 80% loss of the distribution to unsecured creditors resulting from tax liability thrust in the debtor. The worst case was a wipeout for unsecured creditors and administrative insolvency.
Judge Russin concluded that “the harm to [the owner] from the $3.4 million tax liability is far outweighed by the harm that would be caused by granting stay relief so he could avoid it.” Furthermore, he said that the “harm is mitigated by the fact that [the owner] will also receive significant tax benefits.” The operating and capital loss carryforwards, he said, “could yield $19 million in tax benefits in future years.”
Judge Russin said it is “fundamental” that the rights of shareholders in an insolvent corporation “are subordinate” to the rights of creditors. He found no cause to modify the stay, because doing so would “run afoul” of this “fundamental principle” if avoiding a $3.4 million tax liability was at the expense of unsecured creditors.
Even if there were cause to lift the stay, Judge Russin said that modifying the stay would be “futile.”
Judge Russin cited the IRS Code and Regulations in concluding that the owner “cannot force [the debtor] to revoke its S election” and said that he “would certainly not order the officers and directors of [the debtor] to breach their fiduciary duties by doing so.”
Judge Russin closed his opinion by saying that Sub S status is estate property protected by the automatic stay. He saw no “cause” to lift the stay, “because the harm from lifting the stay far outweighs the harm in keeping it in place.” If there were cause, he said, “it would be inappropriate to grant stay relief when stay relief would be futile.”
Deciding that the “syllogistic reasoning” of the Third Circuit was “faulty,” Bankruptcy Judge Peter D. Russin of Fort Lauderdale, Fla., instead followed several lower courts and held that a debtor’s status as a Subchapter S corporation is estate property that the owner cannot terminate in view of the automatic stay.
Even if the owner were entitled to a stay modification, Judge Russin also ruled in his October 6 opinion that the power to terminate a Subchapter S election rests in the corporation, not in the owner.