A Majestic Decision: Delaware Bankruptcy Court Holds Debtor’s QSub Tax Status Is Property of the Estate (Part One)

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Contributed by Yvanna Custodio and Max Goodman

Judge Kevin Gross of the U.S. Bankruptcy Court for the District of Delaware recently decided a novel issue regarding whether a debtor-subsidiary’s beneficial tax status as a particular kind of flow-through entity constitutes property of that debtor’s estate.  Courts have previously held that certain beneficial tax attributes (such as net operating losses, or “NOLs”) constitute property of the estate.  Although it is well established that a debtor’s status as an S corporation for federal and state income tax purposes is property of that debtor’s estate, no court had previously decided whether the same holds true for a debtor’s status as a qualified subchapter S subsidiary (a “QSub”).  In the opinion, the court also decided (i) whether the non-debtor parent’s revocation of its own S corporation tax status, which automatically terminated the debtor’s QSub status, was an avoidable transfer pursuant to section 549 of the Bankruptcy Code (which permits a debtor to avoid an unauthorized postpetition transfer of estate property) and (ii) whether the non-debtor parent’s revocation of its own S corporation status violated the automatic stay.  In today’s blog entry, we discuss the background of the case and the court’s ruling regarding whether a debtor-subsidiary’s QSub status is property of that debtor’s estate.  In the second part of the entry, we will discuss additional arguments as to whether the debtor’s QSub status was property of the estate as well as the court’s ruling on whether the non-debtor parent’s revocation of its own S corporation status was an avoidable transfer and/or violated the automatic stay.

The debtors in Majestic Star Casino, LLC v. Barden Development, Inc. (In re Majestic Star Casino, LLC) operate as a gaming company that owns casinos in several states.  Barden Development, Inc., an S corporation, is the debtors’ non-debtor parent, and its sole shareholder is Don H. Barden.  The Majestic Star Casino II, Inc., one of the debtors, was organized as a QSub.

An S corporation generally is taxed as a pass-through entity, which means that income and losses pass through the corporation to its shareholders, subjecting the shareholders to only one level of taxation.  This stands in contrast to a C corporation, which is the more standard corporation, as to which income is said to be subject to two levels of taxation, once at the corporate level and again at the shareholder level (when distributed).  A corporation that meets certain criteria may elect to be taxed as an S corporation (rather than a C corporation) as long as all of the shareholders at the time of such election consent to it.  Similarly, an S corporation may elect to treat a wholly-owned corporate subsidiary that meets certain criteria as a QSub, in which case (i) the separate corporate existence of the subsidiary is disregarded for federal (and often state) income tax purposes, (ii) its assets and liabilities are treated as the assets and liabilities of the S corporation, and (iii) its income and losses pass through to the S corporation and then to the S corporation’s shareholders.  All other corporate subsidiaries of an S corporation are taxed as C corporations.

As a result of Barden Development’s S corporation status and Majestic Star’s QSub status, income and losses of Majestic Star flowed through to Barden Development’s sole shareholder, Mr. Barden.  Because Majestic Star generated NOLs prior to the events at issue, this allowed such NOLs to flow up to Mr. Barden to offset income on his personal tax return.

After the debtors filed for protection under chapter 11 of the Bankruptcy Code, Mr. Barden presumably realized that any net income generated by Majestic Star during its bankruptcy case (such as income from cancellation of debt and/or gain from asset sales) would flow up to his personal tax return as long as Barden Development and Majestic Star remained flow-through entities.  Accordingly, after the petition date and without court approval, Barden Development filed a notice with the Internal Revenue Service revoking its status as an S corporation (which revocation was permissible under the Internal Revenue Code).  Such revocation resulted in the automatic termination of Majestic Star’s QSub status.  Barden Development and Majestic Star then became C corporations and thus became responsible for filing their own tax returns and paying taxes on their net income for federal and state income tax purposes.  Indeed, Majestic Star paid approximately $2.26 million of estimated state income tax payments due to the loss of its QSub status that it otherwise would not have had to pay.

To decide whether Barden Development’s revocation of its S corporation status – which resulted in the automatic termination of Majestic Star’s QSub status – was an avoidable transfer of property of the bankruptcy estate and/or violated the automatic stay, the bankruptcy court first considered whether Majestic Star’s QSub status constituted property of its estate.

The court, applying the expansive definition of property pursuant to section 541 of the Bankruptcy Code, held that Majestic Star’s QSub status constituted property of Majestic Star’s estate.  The court cited and relied on several cases that have found that debtors have a property interest in their tax status as S corporations and noted that “some of those courts have held that the ‘S’ corporation’s status is property of the estate because of the tax benefits that status confers on the debtor.”  The court then extended such reasoning to Majestic Star’s QSub status, explaining that its QSub status allowed Majestic Star to pass through tax liability on its income to its shareholder.

By revoking Barden Development’s S corporation status, Mr. Barden ensured the automatic termination of Majestic Star’s QSub status, thus preventing income from flowing through to him.  The court observed that the revocation shifted “a potentially significant tax burden . . . from Barden, as controlling shareholder of pass-through ‘S’ corporation entities, back to the [d]ebtors.”  As a result of the termination of Majestic Star’s QSub status, Majestic Star potentially would be liable for taxes on its net income, and such liability would reduce its creditors’ recovery.  The court held that, in view of case law holding that debtors have a property interest in their S corporation status because of the benefits such status accords the debtors, the significant tax benefits provided to Majestic Star in its chapter 11 case accorded it a property interest in its QSub status.

Stay tuned for Part Two of our blog article, in which we discuss additional arguments as to whether Majestic Star’s QSub status was property of the estate made by Mr. Barden, Barden Development, and the Internal Revenue Service, as well as the court’s ruling on whether the non-debtor parent’s revocation of its own S corporation status was an avoidable transfer and/or violated the automatic stay.