Subchapter S Revocation as Fraudulent Transfer? Courts are Finally Getting it Right!

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Whose property is this?

By Donald L. Swanson

“For the reasons set forth below, the Court holds that S corporation status is not ‘property’ for the purposes of 11 U.S.C. §§ 544(b), 548.”

–Judge Kevin R. Huennekens in Arrowsmith v. USA (In re Health Diagnostic Laboratory, Inc., Case No 17-04300, Doc. 54 (Bankr.E.D.Va., December 6, 2017).

The reasons identified by Judge Huennekens in the Arrowsmith opinion are sound and appear to be an important step toward overriding erroneous rulings of the past.

Arrowsmith Facts

Health Diagnostic Laboratory, Inc., provided clinical laboratory services to physicians. But it ran into legal problems with the U.S. Government and filed Chapter 11 bankruptcy on June 7, 2015.

Debtor had been a subchapter S corporation since 2009. But Debtor’s shareholders revoked the S election six months before filing bankruptcy, leaving Debtor with a subchapter C status at filing.

Debtor’s liquidating trustee, Richard Arrowsmith, filed an adversary proceeding to avoid the subchapter S revocation as a fraudulent transfer [Footnote 1]. The Bankruptcy Court rejected and dismissed such claims [Footnote 2].

Subchapter C and Subchapter S Corporations Distinguished

Here is an attempt to explain differences between subchapter C and subchapter S corporations.

–Legalities

The income of a C corporation is taxed twice: (i) the corporation pays tax on its own income, and (ii) its dividends are taxed as income to its shareholders.

The income of an S corporation is taxed only once: the corporation’s income tax liability is passed to its shareholders, who must report and pay the corporation’s income tax as their personal liability.

–S corporations commonly reimburse shareholders for the pass-through taxes they pay.

Unless a corporation qualifies and elects to be a subchapter S corporation, it is a subchapter C corporation.

–Practicalities

S corporation status is great for shareholders when business is humming along, because they avoid large amounts of double taxation.

But when the corporation fails financially, things can turn sour. At the time of failure, shareholders often want to have a C corporation. Here’s a hypothetical showing why:

–A corporation owns lots of real property that has appreciated in value since the time of purchase, and it owns lots of machinery and equipment that is fully depreciated.

–So, when the real and personal property are liquidated, capital gains taxes will be huge, and the corporation has no money to cover the tax liability.

–S corporation shareholders are liable for the capital gains taxes, but they aren’t in a C corporation.

Arrowsmith Question and Prior Answers

As a result, shareholders of a failing S corporation might want to revoke their S election and return to a C corporation status. The question is:

–Can they do this?

Until recently, the courts have answered like this:

–No. And such a revocation is avoidable in bankruptcy as a fraudulent transfer under §§ 544 & 548 or as an unauthorized transfer under § 549 of the Bankruptcy Code.

But that answer is changing—and for good reason. The courts are finally getting-it-right. And the Arrowsmith ruling is an important step in the getting-it-right process.

Arrowsmith Ruling and Analysis

The Bankruptcy Court held a preliminary hearing in Arrowsmith on whether the subchapter S status qualifies as the debtor’s “property” for fraudulent transfer purposes. The Court then issued this ruling and dismissed the fraudulent transfer claims:

–“S corporation status is not ‘property’ for the purposes of 11 U.S.C. §§ 544(b), 548.”

Here are the reasons the Bankruptcy Court gives for its ruling.

1. Federal Law Controls

Federal law “creates the bankruptcy estate.” But state law “determines whether a given property falls within this federal framework,” unless there is “a countervailing federal interest.”

In this case, “there is clearly a countervailing federal interest,” since S corporation status “is a creature of federal law under subchapter S of the Tax Code.”

2. Factors to be Weighed

“[C]ertain 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” these six factors “to determine whether the interest in S corporation status constitutes ‘property’ for federal tax purposes.”

–Factor (1)

Only the first of these factors favors “classifying S corporation status as property”: the ability to use S corporation status to pass tax liability through to shareholders. But this “right to use” factor is weak without the additional rights of “control and disposition.” Like the right to use a borrowed tool, Debtor’s right to use the S classification “existed only until” that classification terminated.

–Factor (2)

As to the second factor, Plaintiff planned to create value by pursuing this elaborate series of events,

(i) avoiding the S revocation for the 2015 tax year,
(ii) refiling Debtor’s 2015 income tax return as an S corporation and reporting a loss, which will pass through to the shareholders,
(iii) requiring shareholders to amend their tax returns to apply Debtor’s losses and create personal tax refunds, and
(iv) demanding the delivery of those refunds to the bankruptcy estate.

However, such a plan to create value (even if the plan is effective) does not create a property right:

–“A beneficiary’s interest in a life insurance policy,” for example, “may be valuable” to the beneficiary but is not “property of the beneficiary,” because the policy owner can change the beneficiary or cancel the policy at any time;

–“Similarly, a corporation cannot claim” a property interest in “a valuable benefit that another party has the power to legally revoke at any time”; and

–Any value from the S election is intended by Congress for the benefit of the shareholders—not the corporation.

–Factors (3) – (6)

“Most importantly,” corporations have “very little control over S corporation status” because shareholders “have the overwhelming ability to control” it.

Moreover, an S corporation “does not have a vested interest in its tax status” because revocation of the election “may be achieved in one of three ways”:

–“by the consent of majority of shareholders and the corporate entity”

[The Arrowsmith opinion notes: “It is unrealistic to suggest that a corporation could ever revolt against its shareholders by refusing to file the revocation form.”];

–“when the corporation ceases to be a considered a small business corporation”

[Note: A “slight change in corporate form could shatter a corporation’s S corporation status without the corporation filing a revocation form.” The “sale by a shareholder of one share of stock” to an unauthorized person, for example, “would automatically dissolve a corporation’s S corporation status.”]; or

–when “passive investment income” reaches certain levels in certain circumstances.

All three ways “are contingent on shareholder or market action,” and the corporation “has no unilateral control over any of” such events. Put another way, the “tax status of the entity is entirely contingent on the will of the shareholders.”

3. Other Details.

S corporation status:

–is not “reflected as an asset on a corporation’s balance sheet”;
–cannot be “transferred by the corporation to an acquiring company”; and
–does not “produce income.”

Instead, S corporation status is “a statutory privilege that qualifying shareholders can elect in order to determine how income otherwise generated is to be taxed.”

4. Rejecting Prior Case Law and NOL Analogy

A series of contrary court rulings date back to these two opinions:

Guinn v. Lines (In re Trans-Lines West, Inc.), 203 B.R. 653 (Bankr. E.D. Tenn. 1996); and
Parker v. Saunders (In re Bakersfield Weststar), 226 B.R. 227 (B.A.P. 9th Cir., 1998).

Each of these two opinions declares the revocation of a subchapter S election to be a transfer of a property interest that can be avoided in bankruptcy. And each relies, by analogy, upon prior legal opinions finding that net operating losses (NOLs) qualify as property of the bankruptcy estate.

The Arrowsmith opinion directly and explicitly rejects these two opinions and their NOL analogy. The Arrowsmith opinion declares that a corporation’s subchapter S status “differs markedly” from a corporation’s NOLs in three respects:

(i) “a taxpayer corporation has the right to exclude others from an NOL, while a corporation cannot exclude others from using S corporation status”;

(ii) “the taxpayer has much more control over an NOL than over S corporation status”: for example, “NOLs cannot be revoked or terminated by another party, unlike S corporation status, which can be terminated by shareholder action”; and

(iii) “an NOL is transferable to other entities, while S corporation status cannot be transferred.”

5. Complementary Bankruptcy Code and Tax Code Provisions

The S corporation status comes with “beneficial and burdensome consequences,” and the Bankruptcy Code “explicitly defers to these tax consequences.”

And there are strict requirements in both Codes. For example:

–“Neither the Bankruptcy Code nor Tax Code allow for a trustee to choose the tax status of the entity.”

–“The Bankruptcy Code requires that a trustee furnish returns for any year where a return was not filed.”

–“The Tax 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.’”

The Debtor in Arrowsmith “was a C corporation for tax purposes in 2015” and was “required to file as such.” And the Plaintiff “cannot use the fraudulent transfer provisions of the Bankruptcy Code to maneuver around the strict requirements of the Tax Code.”

Conclusion

The rationale articulated by the Arrowsmith Court makes sense. And the errors of contrary court rulings from years past are now being revealed. Fortunately, it looks like such errors of the past are on their way to the dust bin.  Hopefully, they’ll arrive in that bin quickly.

Footnote 1: The case is in Arrowsmith v. USA (In re Health Diagnostic Laboratory, Inc., Case No 17-04300 (Bankr. E.D. Va.).

Footnote 2: The Arrowsmith ruling (Doc. 54, dated December 6, 2017) follows the rationale articulated by the U.S. Third Circuit Court of Appeals in Majestic Star Casino, LLC v. Barden Dev., Inc. (In re Majestic Star Casino, LLC), 716 F.3d 736 (3rd Cir. 2013).

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