Revoking S Corp. Status: A Fraudulent Conveyance?
December 18, 2017
Worlds Collide?
I like to tell my partners that there are Codes (upper case “C”), and there are codes (lower case “c”). The former include the Ten Commandments, the Code of Hammurabi, the Code of Justinian, and the Internal Revenue Code. The latter include the Pirate’s Code – which, as Captain Barbossa tells us in the movie Pirates of the Caribbean, “is more what you’d call ‘guidelines’ than actual rules” – and the Bankruptcy code.[1]
Notwithstanding the great divide that normally separates these two sets of coda, the space-time continuum is sometimes warped in such a way that they overlap, as they did in a recent decision of the bankruptcy court that considered whether a debtor-corporation’s status as an “S corporation” for tax purposes should be considered “property” for the purposes of the Bankruptcy code (the “BC”).
“S” Election as “Property”?
Debtor was a privately-held company. As a result of a large settlement and the resulting adverse effects on its business, Debtor’s relationship with its secured lender became severely strained. Debtor eventually defaulted under its loan facilities. In response, the lender discontinued debtor’s borrowing ability and cut off its access to its existing accounts. With no ability to access its cash and with no alternative sources of financing immediately available, Debtor was forced to file for protection under Chapter 11 (“reorganization”) of the BC, following which the U.S. Trustee appointed a committee of unsecured creditors.
However, prior to filing its voluntary petition, and with the consent of a majority of its shareholders, Debtor revoked its election to be treated as an S corporation for tax purposes, though it continued to satisfy the criteria for such status.[2]
Pre-Petition
During the period that Debtor was classified as an S corporation, each shareholder – and not Debtor – reported, and paid tax on, his share of Debtor’s taxable income as reflected on the Sch. K-1 issued by Debtor to the shareholder.
In accordance with Debtor’s Shareholders’ Agreement, Debtor made distributions to its shareholders to reimburse them for Debtor’s pass-through tax liability. Debtor also made direct payments of tax to the IRS on behalf of its shareholders.
As a result of revoking its “S” election, Debtor became subject to corporate-level tax as a “C” corporation, and its shareholders – to whom distributions from Debtor would likely have ceased after the filing of its petition – were no longer required to report its income on their personal returns.
C vs S Corps
Under the Code, a corporation’s “default” status is as a “C corporation,” the net income of which is subject to two levels of taxation: once at the corporate level, and then to the shareholders when distributed to them as dividends.[3]
In contrast to C corporation status, S corporation status confers “pass-through taxation.” S corporations pass corporate income, gains, losses, deductions, and credits to their shareholders, who must report their respective shares of the income and losses of the S corporation on their personal income tax returns.
Sale of Assets
A couple of months following Debtor’s petition, the Court entered an order which authorized the sale of substantially all of Debtors’ operating assets to Buyer, and the sale occurred shortly thereafter. The Court then confirmed Debtor’s Plan of Liquidation, pursuant to which the Liquidating Trust was formed as the successor to Debtor and to the unsecured creditors committee.
The Liquidating Trustee filed a complaint against the IRS and Debtor’s shareholders, seeking to avoid the revocation of Debtor’s S corporation status as a fraudulent transfer of property under the BC.[4]
The U.S. filed a motion to dismiss the complaint because, it stated, “a debtor’s tax status is not ‘property’.”
Other Courts
The Court noted that only a handful of courts have considered this issue in the context of fraudulent transfers. Of these courts, only the Third Circuit concluded that S corporation status did not constitute a property right in bankruptcy; all of the others found S corporation status to be a property right in bankruptcy.
Some of the courts that found a property right defined “property” under the BC as something that a person has rights over in order to use, enjoy, and dispose of. These courts reasoned that a debtor corporation did have a property interest in its S corporation status on the date that the status was allegedly “transferred” because the Code “guarantees and protects an S corporation’s right to dispose of [the S corporation] status at will.” Until such disposition, the corporation had the “guaranteed right to use, enjoy, and dispose” of the right to revoke its S corporation status. Consequently, these courts held that the right to make or revoke S corporation status constituted “property” or “an interest of the debtor in property.”
In contrast, the Third Circuit, reviewing a post-petition revocation, concluded that S corporation status did not constitute an interest of a debtor corporation in “property” in a bankruptcy case.
Court’s Analysis
The issue before the Court was whether Debtor’s S corporation status was an interest in “property” that was subject to transfer. If it was not, then the “S” election was not subject to the fraudulent transfer provisions of the BC.
The Court explained that the issue whether S corporation status is “property” for the purposes of the BC was a question of law. The fraudulent transfer provision allows a trustee to avoid obligations voidable under state law. The fraudulent transfer provision allows a trustee to avoid certain transfers that occurred two years prior to the petition date.
The Court acknowledged that the property of the bankruptcy estate is composed of “all legal or equitable interests of the debtor in property as of the commencement of the case.” Congressional intent, it stated, indicates that “property” under the BC is a sweeping term and includes both intangible and tangible property.
Defining “Property”
However, it continued, no BC provision “answers the threshold questions of whether a debtor has an interest in a particular item of property and, if so, what the nature of that interest is.” Property interests are created and defined by state law, unless some countervailing federal interest requires a different result.
Normally, the “federal [tax] statute ‘creates no property rights but merely attaches consequences, federally defined, to rights created under state law.’” Once “‘it has been determined that state law creates sufficient interests in the [taxpayer] to satisfy the requirements of [the statute], state law is inoperative,’ and the tax consequences thenceforth are dictated by federal law.”
In this case, the Court stated, federal tax law governed any purported property right at issue. There was clearly a countervailing federal interest because S corporation status is a creature of federal tax law. State law created “sufficient interests” in the taxpaying entity by affording it the requisite corporate and shareholder attributes to qualify for S corporation status; at that point, “‘state law [became] inoperative,’ and the tax consequences [were] dictated by federal law.” Federal tax law, which was dependent on certain state law conclusions, dictated whether S corporation status was a property right for purposes of the BC.
The Court recognized that certain interests constitute “property” for federal tax purposes when they embody “essential property rights,” which include (1) the right to use; (2) the right to receive income produced by the purported property interest; (3) the right to exclude others; (4) the breadth of the control the taxpayer can exercise over the purported property; (5) whether the purported property right is valuable; and (6) whether the purported right is transferable. A reviewing court must weigh those factors, it stated, in order to determine whether the interest in S corporation status constitutes “property” for federal tax purposes.
Applying these “essential property rights” factors, the Court observed that only one of the factors leaned in favor of classifying S corporation status as property; specifically, Debtor’s ability to use the S corporation tax status to pass its tax liability through to its shareholders. However, according to the Court, the “right to use” factor was the weakest of the “essential property rights.” Without the rights of control and disposition, the right to use was “devoid of any meaningful property interest,” the Court stated. While Debtor may have had the right to use the S corporation status, it lacked the ability to control the use of its tax classification. The right to use the classification existed only until termination.
The second factor, that the tax classification was valuable, did not lean in favor of finding that S corporation status qualified as a property right. The Liquidating Trustee hoped to generate value through avoidance of the “transferred” S corporation revocation, thus retroactively reclassifying Debtor as an S corporation during that taxable year. The Liquidating Trustee believed that by doing so, Debtor’s losses would pass through to its shareholders (to the extent of their basis in Debtor stock), offsetting other income on their personal returns, and thereby generating refunds that the Liquidating Trustee intended to demand from the shareholders for the benefit of the Liquidating Trust and the creditors.[5]
In response to this “plan,” the Court pointed out that, though something may confer value to the estate, it does not necessarily create a property right in it.
Similarly, the Court continued, a corporation cannot claim a property interest to a valuable benefit that another party has the power to legally revoke at any time.
The Court explained that the “S” election removes a layer of taxation on distributed corporate earnings by permitting the corporation to pass its income through to the corporation’s shareholders. The benefit is to the shareholders — it allows them to avoid double taxation. 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.
The remaining factors, the Court continued, also leaned in favor of finding that S corporation status did not constitute a property right under federal tax law. Most importantly, a corporation has very little control over its S corporation status, yet the right to exercise dominion and control over an interest is an essential characteristic defining property.
Shareholders have the overwhelming ability to control the tax status of their corporation. Election of S corporation status may be achieved by one method—unanimous shareholder consent; the corporation does not elect S corporation status. Thus, any interest in electing S corporation status belongs to the shareholders.
The Court stated that an S corporation does not have a vested interest in its tax status after the election has been made. Rather, termination of S corporation status – including by the consent of majority of shareholders – is contingent on shareholder action; the corporation has no unilateral control over the revocation of its S corporation status.
For example, the sale by a shareholder of one share of stock to a partnership would automatically terminate a corporation’s S corporation status. As the S corporation election could be terminated voluntarily by the actions of any one shareholder, it is impossible to state that a corporation has complete control over its S corporation status. Unilateral shareholder action could extinguish S corporation tax status without the corporation taking any action.
The Court observed that S corporation status is not reflected as an asset on a corporation’s balance sheet; it is not something of value that can be transferred by the corporation to an acquiring company; it does not produce income. Rather, S corporation status is a statutory privilege that qualifying shareholders can elect in order to determine how income otherwise generated is to be taxed.
The Court ended its analysis by noting that neither the BC nor the Code allow for a trustee to choose the tax status of the entity. Rather, the BC requires that a trustee furnish returns for any year where a return was not filed as required. Similarly, the Code requires that a trustee “make the return of income for such corporation in the same manner and form as corporations are required to make such returns.” In this case, Debtor was a C corporation for tax purposes. Debtor was required to file as such. The Liquidating Trustee could no use the fraudulent transfer provisions of the BC to maneuver around that requirement.
After weighing all the factors, the Court held that S corporation status was not property under the Code. Although a corporation and its shareholders could elect to use S corporation status in order to avoid double taxation, that factor alone was not enough to outweigh all the remaining characteristics essential to qualify tax status as a property right.
Accordingly, Debtor’s S corporation status could not be considered “property” for the purposes of the BC, and there was no transfer of Debtor’s interest in property that was subject to avoidance under of the BC.
Takeaway?
A financially distressed S corporation make be forced to sell properties in order to generate liquidity with which to pay creditors, or it may negotiate for the cancellation of certain indebtedness owing to such creditors.
These transactions may generate gain or income[1] that will flow through, and be taxable, to the corporation’s shareholders. Moreover, it is likely that the corporation’s creditors will not permit it to make cash distributions to its shareholders to enable them to pay the tax on the flow-through income or gain.
On the other hand, a distressed S corporation has likely generated substantial losses, having lost not only its undistributed income and its shareholders’ capital contributions, but also the funds acquired via loans from third parties and from 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.
The flow-through of income or gain to the shareholders would increase their debt and stock bases (in that order), thereby allowing them to utilize some, though perhaps not all, of their suspended losses. It is also possible that the income or gain will exceed the available losses, thus resulting in a net cash outlay by the shareholders for taxes owing.
Of course, if the “S” election were revoked prior to the corporation’s filing its petition, the foregoing issues may be averted, though the corporation’s creditors may object (as the Liquidating Trustee did in the decision discussed above) because any gain or income, and the related tax liability, resulting from the sale or debt cancellation would be captured at the level of the corporate debtor.
At the end of the day, it will behoove the debtor S corporation to consult its tax and bankruptcy advisers well before approaching its creditors, and to thoroughly analyze the foregoing issues and options before deciding to revoke its tax status.
[1] With apologies to the Title 11 Bar? Nah.
[2] Fewer than 100 individual shareholders, one class of stock, etc.
[3] The Tax Cuts and Jobs Act (H.R. 1), on which the House and Senate will be voting this week, would reduce the corporate income tax rate to 21%, effective January 1, 2018. If enacted, we will cover this legislation in later posts.
[4] For example, the trustee may avoid any transfer of a debtor’s interest in property: that was made within 2 years before the date of the filing of the petition if the debtor made such transfer with intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made, indebted; or for which it received less than a reasonably equivalent value in exchange for such transfer; or was insolvent on the date that such transfer was made, or became insolvent as a result of such transfer.
[5] The Trustee’s plan was a bit more convoluted than this. You can’t make this stuff up.
[6] The application of the Code’s bankruptcy and insolvency exceptions to COD income is made at the level of the S corporation.