Contributed by Debra McElligott
Are a debtor’s net operating losses considered property of the estate when they are reported on a consolidated tax return by a non-debtor parent? We previously wrote about this issue here. The United States Bankruptcy Court for the District of Delaware recently considered this question (and shed some light on factors that might affect the answer) in Stanizale v. Coppercom, Inc. (In re Conex Holdings, LLC).
The Debtor’s Net Operating Losses
From 2008 to 2011, the parent company of Conex Holdings, LLC filed consolidated tax returns for its subsidiaries. The debtor, a sole member limited liability corporation, was treated as a “disregarded entity” under the Internal Revenue Code, meaning the entity’s separateness from its sole member (in this case, the parent company) was disregarded for federal income tax purposes. The parent company used the debtor’s net operating losses (NOLs) to reduce the taxable income of its profitable subsidiaries. The debtor recorded this benefit to the parent on its books as a receivable, which was never paid. According to the complaint, the debtor and the parent company also had an implied-in-fact tax allocation agreement with respect to the debtor’s 2009 and 2010 NOLs, as the debtor recorded the tax benefit derived from the use of these NOLs in its books on a monthly basis.
After the debtor and its affiliates filed for bankruptcy, the chapter 7 trustee filed an adversary proceeding against the debtor’s parent company. Among other things, the trustee sought turnover pursuant to section 542 of the Bankruptcy Code of an open receivable in connection with the parent company’s use of the debtor’s 2008 NOL. The trustee also sought to avoid and recover the value of the debtor’s 2010 and 2011 NOLs under sections 549 and 550 of the Bankruptcy Code. The parent company filed a motion to dismiss.
Turnover and the Tax Code
The trustee asserted a turnover claim in connection with the use of the 2008-2011 NOLs under section 542 of the Bankruptcy Code, which requires an entity in possession of property of the estate to give the property or its value to the debtor. The court cited its opinion in In re Hechinger Investment Co. of Delaware, Inc. for the principle that a properly pleaded turnover claim must allege an “undisputed right to recover the claimed debt.” The court held that the trustee failed to do so in this case because it alleged that the debtor’s assets were treated as the parent’s because of its “disregarded entity” status, but also alleged that the benefit derived by the parent was a receivable due and owing to the debtor. The court also noted that section 542 is “a remedy available to debtors to obtain what is acknowledged to be property of the bankruptcy estate,” and that, because the right to use the debtor’s NOLs passed to the parent by operation of the Internal Revenue Code, any tax benefits derived solely benefitted the parent. Finally, the court distinguished cases holding that NOLs are property of the estate in the context of a tax allocation agreement, as these cases involved tax-paying C-corporations, not single member LLCs that have not elected to be taxed as corporations.
Avoidance and Allocation Agreements
Additionally, the trustee asserted an avoidance claim to recover its 2010 and 2011 NOLs under sections 549 and 550 of the Bankruptcy Code, alleging that these particular transfers were made pursuant to the implied-in-fact tax allocation agreement between the debtor and its parent. Section 549 allows a trustee to avoid a transfer of property of the estate that occurs after the commencement of the case and that was not authorized by any provision of the Bankruptcy Code or by order of the bankruptcy court. The court held that, due to the debtor’s status as a disregarded entity, the parent was responsible for filing a consolidated tax return regardless of whether it had entered into a tax allocation agreement with the debtor. As such, no “transfer” occurred within the meaning of section 549 because the parent already directly held the NOLs of the disregarded entity. Additionally, even if the debtor and its parent company had entered into a tax allocation agreement with the parent, any standalone NOLs the debtor calculated were not property of the estate because they are a “legal fiction” calculated so that the parent could determine the debtor’s individual NOLs for purposes of the consolidated tax return.
Interestingly, although the bankruptcy court dismissed the turnover claim with prejudice, it dismissed the avoidance action without prejudice and granted the trustee leave to replead its claim. The court noted that because the trustee failed to allege that the NOLs had value to the debtor, the policy behind avoidance actions – allowing debtors to recover property in order to satisfy creditors’ claims – was not implicated. The opinion suggests that the bankruptcy court might come to a different conclusion when faced with a set of facts demonstrating the value of particular NOLs to the debtor (and, in turn, its creditors).