The Problem of Pass-Through Tax Liability from Liquidation of a Family Business — A Chapter 11 Solution?

By: Donald L. Swanson

Hypothetical: A family business has been successful for many years. But obsolescence of its products and services is taking a toll: the business is now insolvent, its assets are fully encumbered, no one is interested in buying the business as a going concern, and family shareholders have guaranteed most of its debts.

So, the family wants to liquidate its business assets.

The Problems

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Passing-through

The legal problem: The family business is conducted in a subchapter S corporations. In an S corporation, income tax liability passes through to the shareholders—it is the shareholders, not the corporation, who are personally liable for the corporation’s income taxes.

[Note: The idea of an S corporation is to avoid double taxation—the first taxation is on income of the corporation, and the second taxation is on dividends to shareholders. C corporations are where double taxation occurs.  But in a C corporation, only the corporation—and not its shareholders—is responsible for its income taxes.  Generally, when a business is prospering, owners want S status; but when the business is heading toward liquidation, C status is best.]

The practical problem: The hypothetical family corporation, (i) bought real estate many years ago, which have a low tax basis today, and (ii) has fully depreciated its equipment assets. Thus, in a liquidation of the corporation’s real estate and equipment:

  • The amount of capital gains taxes will be huge; and
  • Such taxes will become the personal obligation of family shareholders.

So, the family shareholders find themselves in a choice between two impossible alternatives: either, (i) keep the failing business running by infusing new money and incurring more personally-guaranteed debt, or (ii) liquidate the business assets and incur huge tax liabilities, personally.

A Circuit Split

A few U.S. circuit courts of appeals have address the question of whether an insolvent corporation changing from S to C status, before liquidation, would be a fraudulent transfer.

–Third Circuit

In the Third Circuit (which covers federal courts in Delaware, New Jersey, Pennsylvania and the Virgin Islands), the family business could simply change its corporate status from Subchapter S to Subchapter C and then proceed with liquidation. See, Majestic Star Casino, LLC v. Barden Dev., Inc. (In re Majestic Star Casino, LLC), 716 F.3d 736 (3rd Cir. 2013).

The theory is this: a debtor’s S corporation status is not “property” of the bankruptcy estate; therefore, changing that status from S to C cannot be avoided as a fraudulent transfer.

–Eighth and Ninth Circuits

In other U.S. circuit courts of appeals, however, an S corporation status is “property” of the bankruptcy estate, so that a change to C status could be avoided as a fraudulent transfer.

1.  In the Ninth Circuit (which covers federal courts in Alaska, Arizona, California, Hawaii, Idaho, Montana, Nevada, Oregon, Washington, Guam and the Northern Mariana Islands), the U.S. Circuit Court of Appeals declared:

A debtor’s right to “make or revoke” a subchapter S election is an “interest of the debtor in property,” so that a debtor’s prepetition revocation of its subchapter S election is a “transfer” of property under fraudulent transfer statutes.

Parker v. Saunders (In re Bakersfield Westar), 226 B.R. 227, 237 (B.A.P. 9th Cir. 1998).

 2.  In the Eighth Circuit (which covers federal courts in Arkansas, Iowa, Minnesota, Missouri, Nebraska, North Dakota and South Dakota), the Bankruptcy Appellate Panel cited and followed the Ninth Circuit’s Parker v. Saunders decision and declared:

“a corporation’s right to use, benefit from, or revoke its Subchapter S status falls within the broad definition of property of the estate.”

Halverson v. Funaro (In re Frank Funaro, Inc.), 263 B.R. 892, 898 (B.A.P. 8th Cir. 2001).

–Other Circuits

For federal courts in other areas, where courts of appeals have yet to speak, bankruptcy courts are still free to choose their own way.

One example (discussed in this linked article) is in the Eastern District of Virginia, where the Bankruptcy Court followed the Third Circuit and declared: “S corporation status is not ‘property’” under fraudulent transfer statutes.  See, Arrowsmith v. USA (In re Health Diagnostic Laboratory, Inc.), Case No. 17-04300 (Bankr. E.D. Va.) (Doc. 54 Opinion, 12/6/2017)).

A Solution?

For family businesses outside the Third Circuit, and particularly for those in the Eight and Ninth Circuits, shareholders in the hypothetical face a problem that needs to be addressed.

So . . . here’s a two-part solution for such businesses, using Chapter 11:

  1. Provide for a conversion from S corporation to C corporation status, upon confirmation of Debtor’s Plan, so the reorganized debtor is a C corporation, with liquidation of assets occurring after confirmation; and
  2. Address absolute priority rule issues in the manner identified in this linked article?

What do you think? Wouldn’t such a Chapter 11 plan, (i) be confirmable, and (ii) shield shareholders from capital gains tax liabilities arising from liquidation?

Some Variations

Or . . . let’s change the hypothetical to a group of limited liability companies, which are changed by plan confirmation into C corporations for the reorganized debtor, before liquidation?
Or . . . how about the business assets of a sole proprietorship being transferred, upon confirmation, into a C corporation, as the reorganized debtor, before liquidation?

Conclusion

So . . . what do you think about the solution described above?
And what about using the solution in limited liability company or sole proprietorship contexts?
Wouldn’t the solution work to confirm a Chapter 11 plan and avoid personal liability for capital gains taxes arising from liquidation?

** If you find this article of value, please feel free to share. If you’d like to discuss, let me know.

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