The Third Circuit Court of Appeals ruled that a debtor corporation did not have a property interest in its status as a qualified subchapter S subsidiary, and as a result, the debtor corporation's parent and the parent's sole individual shareholder did not cause an improper prepetition transfer of property under the Bankruptcy Code by terminating the parent corporation's subchapter S status and the debtor corporation's qualified subchapter S subsidiary status.
In Re: The Majestic Star Casino, LLC, No. 12-3200 (3rd Cir. May 21, 2013), Don Barden owned 100% of the outstanding stock of Barden Development Inc. (BDI), an S corporation for federal income tax purposes. BDI, in turn, indirectly owned 100% of the outstanding stock of the Majestic Star Casino II Inc. (MSC II), a qualified subchapter S corporation (QSUB). MSC II, along with certain other entities controlled by Barden, filed for Chapter 11 bankruptcy protection in November 2009. BDI, however, did not join in the bankruptcy filing. After the bankruptcy filing but before the bankruptcy plan was consummated, Barden voluntarily revoked BDI's status as an S corporation, which caused MSC II to lose its status as a QSUB.
MSC II challenged the revocation of BDI's S election, asserting that its QSUB status was "property," and that revocation caused an unlawful post-petition transfer of that property away from MSC II and the bankruptcy estate. The Bankruptcy Court agreed with MSC II and ordered Barden, BDI and the IRS to reinstate BDI's status as an S corporation and MSC II's status as a QSUB. On appeal, the Third Circuit disagreed and vacated the Bankruptcy Court's decision, ruling that the revocation of BDI's S election was not a post-petition transfer of property.
Rejecting prior case law, the Third Circuit reasoned that neither S corporation status nor QSUB status is "property." In addition, the court noted that even if QSUB status was considered property, it would not be the property of MSC II, because such status is entirely under the control of the parent S corporation and the parent's shareholder. The Third Circuit also permitted BDI's S corporation revocation and MSC II's corresponding termination of QSUB status because BDI and Barden - not MSC II - possessed and enjoyed the benefits of MSC II's QSUB status.
The court's holding is important when determining which party bears the tax burden from cancellation of debt income (CODI) triggered when a debtor corporation's debt is canceled upon emergence from bankruptcy. In this case, if MSC II retained its status as a QSUB and BDI retained its status as an S corporation, the CODI would have been recognized by Barden. In addition, the bankruptcy exclusion from CODI under IRC Section 108(a)(1)(A) would presumably not have been available to BDI or Barden because neither was in bankruptcy, even though the bankruptcy exception presumably would be available to MSC II as a debtor C corporation (see Treas. Reg. Sec. 1.108-9).
In summary, the appellate court's decision effectively protects an S corporation and its shareholders from bearing the tax burden of the CODI of a QSUB when only the QSUB is in bankruptcy. Instead, the tax burden is effectively borne by the post-bankruptcy reorganized former QSUB, now a C corporation, and its creditors.
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