For years I have told my partners that there are two kinds of “codes”: those with an upper case “C”, like the Ten Commandments and the Internal Revenue Code, and those with a lower case “c”, like the bankruptcy code.[iii]
There are times, however, when the veil that separates the rarefied world of tax from the gritty struggles of bankruptcy practice is inexplicably pierced and the players from each sphere slip through the openings, either invited or not, to dabble in the other’s affairs.[iv]
This should not come as a surprise to anyone who has advised closely held businesses. Whether the business is just starting out, or is going through some difficult times on its way to recovery and growth, or is on its proverbial last legs, the business or its owners (if the business is a pass-through entity for tax purposes) will have developed or generated certain tax attributes, including net operating losses, the utilization of which may be instrumental either in salvaging the business or in satisfying its creditors.[v]
Debtor, which was formed as a partnership under state law, filed a bankruptcy petition under Chapter 11.[viii] The Court confirmed the “Debtor’s Plan” which, among other things, required Debtor to provide the creditors’ committee (the “Committee”) verification that Debtor was making the payments required under the Plan. If Debtor defaulted, Debtor had thirty days to cure, failing which the Plan provided for the appointment of a Liquidating Trustee to dispose of Debtor’s assets.
Debtor informed the Committee that the revenues necessary to make the payments under the Plan were not going to materialize within the requisite period, and stated “this is the time to name a liquidating agent” under the Plan.
The Committee confirmed the notice of default, and informed Debtor of its intent to move for the appointment of a Liquidating Trustee if Debtor failed to timely cure the default. Debtor failed to cure within thirty days.
The Committee’s motion and proposed order included a provision under which not less than ten-percent of the aggregate gross proceeds from the sale of assets by the Liquidating Trustee would be allocated for payment of allowed administrative expenses and unsecured claims.
Debtor objected to the Committee’s motion for appointment of a Liquidating Trustee.
Debtor argued that any sale of assets would result in a liability for capital gains taxes. It also argued that any sale was unlikely to yield proceeds in an amount sufficient to provide for the payment of such capital gains taxes (which would be payable by the Debtor’s owners) and of the Liquidating Trustee’s fees, Debtor’s attorney fees, and the Committee’s attorney fees.
In addition, although Debtor had previously conceded that it was ineligible to be a debtor under Chapter 12 of the “code” when it filed its petition, Debtor now asserted that its total debts were below the prescribed ceiling amount, making it eligible to proceed under Chapter 12.[ix] Debtor sought to convert to Chapter 12 in order to capitalize on what it referred to as the “Grassley Law” allowing it to treat certain capital gains taxes as unsecured claims. According to Debtor, without a conversion, capital gains taxes from the sale of its assets would render the estate administratively insolvent.
According to the Committee, potential capital gains taxes were a non-issue because Debtor was a partnership, and a pass-through entity, for tax purposes. The Committee pointed out that the partners, and not the partnership, would be liable for any taxes arising from the sale of Debtor’s assets.
Debtor countered that it was eligible to elect to be taxed as an “association” (i.e. as a corporation) under the IRS’s “check the box” regulations.[x] Debtor claimed that if such an election were made,[xi] the corporation’s taxes would be discharged as an unsecured claim under Chapter 12.
According to Debtor, the “best approach” would be for the Court to deny the Committee’s motion for appointment of a Liquidating Trustee, allow the conversion of the proceeding to chapter 12, and confirm a chapter 12 plan incorporating liquidation provisions.
The Court made short work of Debtor’s request that the proceeding be converted to one under chapter 12, stating that Debtor was not a “family farmer.” Its debt exceeded the statutory limit when it filed its petition. According to the Court, conversion does not change the date on which eligibility under chapter 12 is determined. Thus, “under the facts and clear language of the statute,” Debtor was not eligible to convert to chapter 12.
Debtor’s Tax Status
The Court then turned to Debtor’s request to change its tax status from a partnership to an association taxable as a corporation.
Debtor’s Tax Status
Partnerships, for purposes of taxation, are “pass-through entities,” the Court stated. A partnership files an information return,[xii] but the partnership itself is not responsible for taxable gains and losses; rather, such gains and losses pass through to the partners themselves, who report them on their own income tax returns.[xiii]
“A partnership’s bankruptcy filing,” the Court continued, “does not alter its tax status. A partnership is recognized as an entity separate from the partners in bankruptcy proceedings, but not in income taxation.”
Thus, partnership income continues to be taxed as though a bankruptcy case had not been commenced. For purposes of the federal income tax, the commencement of a bankruptcy case by either a partner or a partnership does not alter the tax status of the partnership.
In fact, except in the case of an individual bankruptcy, no separate taxable entity results from the commencement of a case “under Title 11 of the United States Code.”[xiv]
Eligibility for Election
Having established Debtor’s tax status during the bankruptcy, the Court considered its eligibility to change such status.
An “eligible entity” with at least two owners, it stated, can elect to be treated as an association for federal tax purposes. Eligible entities include unincorporated business entities, including domestic partnerships.
Absent such an election, a partnership would continue to be taxed as a partnership. Since its creation, Debtor was a partnership for tax purposes. It never made any other election as to its status. Thus, it continued to be taxed as a partnership. The bankruptcy filing did not impact Debtor’s tax status.
The Court observed that the Code, and the regulations issued thereunder, would permit Debtor to elect to be treated as a corporation for federal tax purposes. Debtor maintained that making such an election “would be beneficial.”
While noting that the election may benefit the partners of Debtor,[xv] the Court further noted that the more relevant question was “whether it benefits [Debtor], its estate and its creditors. As a result, the Court must decide whether a change in election violates the Bankruptcy Code or Plan.”[xvi]
Specifically, the Court considered whether the change in tax status caused by the election would violate the so-called “absolute priority rule.”
The absolute priority rule provides that the owners of a debtor, or those holding an interest in a debtor, will not receive or retain under the bankruptcy plan any property, because of that ownership or other interest, unless all general unsecured claims are paid in full.[xvii]
The fundamental principle underlying the rule is to ensure the plan is “fair and equitable.” The rule prohibits the bankruptcy court from approving a plan that gives the holder of a claim anything at all unless all objecting classes senior to the claimant have been paid in full.[xviii] The rule serves to address what the Court described as “the danger inherent in any reorganization plan . . . that the plan will simply turn out to be too good a deal for the debtor’s owners.”
The Court found that the proposed tax election would violate the absolute priority rule. It was not fair and equitable. By converting Debtor into a taxable[xix] entity, and terminating its pass-through status,[xx] the election would benefit Debtor’s owners to the detriment of its creditors by shifting funds from the creditors to the taxing authorities. It would dilute the class of unsecured creditors.
From the time that Debtor filed its petition, the Court explained, its partners retained the benefit of favorable tax treatment through any depreciation or other losses that flowed through Debtor as a pass-through entity.[xxi]
The partners now sought to effect a change in the tax treatment of Debtor that would have saddled Debtor with substantial capital gains and taxes from the sale of its assets. In other words, the partners would receive a tax benefit (Debtor’s losses and deductions) through favorable tax treatment, and would shift the unfavorable treatment to the detriment of Debtor’s creditors. The absolute priority rule, the Court stated, was designed to prevent such an abuse.
What’s more, the Court continued, Debtor’s disclosure statement[xxii] detailed the tax consequences of the Plan. “There is a possibility that various transfers and transactions contemplated by the Plan would result in a reduction of certain tax attributes . . . including but not limited to . . . capital gains liability”.
At the time of the Court’s confirmation of the Plan, Debtor could have discussed the treatment of capital gains taxes and the possibility of an entity classification election. The Disclosure Statement and Plan both included the Liquidation Provision. Thus, Debtor knew that upon default, a Liquidating Trustee could be appointed and assets sold. There was no unfair surprise to Debtor, but there would be unfair surprise to its creditors. Creditors acted relying on the Disclosure Statement and Plan, which did not include a discussion of a possible change in tax treatment. The Court stated that any election to be taxed as an association should have occurred pre-petition, or at least pre-confirmation.
The Court found it troubling that the Debtor sought to change its tax status to its own detriment and, thereby, to that of its creditors. In general, the Court stated, the two purposes underlying the bankruptcy code are the “debtor’s fresh start and the repayment of creditors.” Debtor’s electing to be taxed as an association, the Court stated, would accomplish neither of these goals. Rather, it would burden Debtor with potentially substantial capital gains taxes, and reduce payments to its creditors. The election would merely allow Debtor’s partners to shift unfavorable tax treatment elsewhere.
The Court determined that the proposed tax election was not in the best interests of Debtor, the estate, or its creditors. Therefore, the Court prohibited the check-the-box election.
Electing Association Status vs. Revoking an “S” Election? [xxiii]
What can we take away from the Court’s opinion? The Court claimed to have based its decision upon the absolute priority rule. At the same time, though, the Court stated that any election by Debtor to be taxed as an association should have occurred pre-petition, or at least pre-confirmation, which is more in line with the purpose of the disclosure statement. So which is it?
A couple of years back,[xxiv] we considered the case of another pass-through entity: a debtor S-corporation which, prior to filing its voluntary petition, revoked its election to be treated as an S-corporation for tax purposes.[xxv] As a result of revoking its “S” election, the debtor became subject to corporate-level tax as a C-corporation, and its shareholders – to whom distributions from the debtor would likely have ceased after the filing of its petition – were no longer required to report its income on their personal returns.[xxvi]
Following the debtor’s petition, the Court authorized the sale of substantially all of the debtor’s operating assets. The sale occurred shortly thereafter, and the Court then confirmed the debtor’s plan of liquidation, pursuant to which a liquidating trust was formed.
The liquidating trustee filed a complaint against the debtor’s shareholders, seeking to avoid the revocation of the debtor’s S-corporation status as a fraudulent transfer of the debtor’s property under the bankruptcy code.[xxvii]
The Court noted that most other courts that had considered the issue found that a debtor’s S-corporation status was a property right in bankruptcy. These courts reasoned that a debtor corporation had a property interest in its S-corporation status on the date that the status was allegedly “transferred” because the Code “guarantees and protects an S corporation’s right to dispose of [the S-corporation] status at will.” Until such disposition, the corporation had the “guaranteed right to use, enjoy, and dispose” of the right to revoke its S-corporation status. Consequently, these courts held that the right to make or revoke S-corporation status constituted “property” or “an interest of the debtor in property.”
The Court acknowledged that the property of the bankruptcy estate is composed of “all legal or equitable interests of the debtor in property as of the commencement of the case.” Congressional intent, it stated, indicated that “property” under the code[xxviii] was a sweeping term and included both intangible and tangible property.
However, it continued, no code provision “answers the threshold questions of whether a debtor has an interest in a particular item of property and, if so, what the nature of that interest is.” Property interests are created and defined by state law, unless some countervailing federal interest requires a different result.
Normally, the “[Code] creates no property rights but merely attaches consequences, federally defined, to rights created under state law.” In that case, the Court stated, federal tax law governed any purported property right at issue because S-corporation status was a creature of federal tax law. State law created “sufficient interests” in the taxpaying entity by affording it the requisite corporate and shareholder attributes to qualify for S-corporation status; at that point, it continued, federal tax law dictated whether S-corporation status was a property right for purposes of the code.
The Court recognized that certain interests constituted “property” for federal tax purposes when they embodied “essential property rights.”[xxix] A reviewing court must weigh these factors, it stated, in order to determine whether the interest in S-corporation status constituted “property” for federal tax purposes.
Applying these “essential property rights” factors, the Court observed that only one of the factors leaned in favor of classifying S-corporation status as property; specifically, the debtor’s ability to use its S-corporation tax status to pass its tax liability through to its shareholders. The liquidating trustee hoped to generate value through avoidance of the “transferred” S-corporation revocation, thus retroactively reclassifying the debtor as an S-corporation. The liquidating trustee believed that by doing so, the debtor’s losses would pass through to its shareholders, offsetting other income on their personal returns, and thereby generating refunds that the liquidating trustee intended to demand from the shareholders for the benefit of the liquidating trust and the creditors.
In response to this “plan,” the Court pointed out that, although something may confer value to the estate, it does not necessarily create a property right in it.
The Court explained that a corporation cannot claim a property interest to a benefit that another party – its shareholders – has the power to legally revoke at any time.[xxx] The “S” election, it stated, removes a layer of taxation on distributed corporate earnings by permitting the corporation to pass its income through to the corporation’s shareholders. The benefit is to the shareholders: it allows them to avoid double taxation. To the extent there is value inherent in the election, it is value that Congress intended for the corporation’s shareholders, and not for the corporation.[xxxi]
After weighing the foregoing, the Court held that S-corporation status could not be considered “property” for purposes of the code, and there was no transfer of the debtor’s interest in property on the shareholders’ revocation of such status that was subject to avoidance under the code.
Absolute priority. Disclosure. Fraudulent Conveyance. A question of timing? A question of property rights? A question of fairness?
A pre-petition election to be treated as an association, or a pre-petition revocation of a corporation’s “S” election, would address the concern over providing creditors sufficient information with which to consider a proposed plan. Their acceptance of the plan, and a court’s confirmation thereof, would seem to bar any further discussion.
However, some creditor is bound to object, probably on the grounds described above.
Regardless of how one frames the argument as a matter of “technical” bankruptcy law, from a non-technical perspective, the election or revocation, as the case may be, shifts the tax liability for the liquidation of the business away from the partners and shareholders and onto the debtor-business entity, which of course reduces the value that will be available to satisfy the claims of the creditors. On a visceral level, that doesn’t seem right, especially in the absence of a bona fide, even compelling, non-tax business reason for effectuating such a change in tax status.[xxxii]
Of course, what feels right is not always consistent with what the law allows in a given set of circumstances. When faced with the prospect of a bankruptcy proceeding, the debtor-taxpayer and its owners should consult with their bankruptcy (and tax) advisers well before making any changes to the debtor’s tax status.
[i] From the opening of The Odd Couple.
[ii] From the ad for Reese’s Peanut Butter Cup. Don’t you miss the ‘70s? Sometimes?
[iii] If you’ve watched bankruptcy folks at work, you know that their code is more like a set of guidelines than actual rules, to paraphrase Captain Barbossa from the first Pirates of the Caribbean movie.
[iv] If you have read Salman Rushdie’s Two Years Eight Months and Twenty-Eight Nights, you’ll understand the reference; if you have not read it, please do.
[v] For example, before the passage of the Tax Cuts and Jobs Act (P.L. 115-97), a troubled taxpayer was able to carry its NOLs back two years in order to generate a refund and some badly needed cash. The Act eliminated the carryback. That being said, it also eliminated the 20-year carryforward, thereby allowing NOLs to be carried forward “indefinitely” – i.e., until they are exhausted – and removing some of the sting from the ownership change rules under Section 382 of the Code, which limit the amount of NOL that may be utilized in any taxable year. At the same time, however, the Act also limited the amount of loss that may be utilized in any tax year to 80-percent of the taxpayer’s taxable income. IRC Sec. 172.
[vi] U.S. Bankruptcy Court for the Western District of Wisconsin, In re: Schroeder Brothers Farms of Camp Douglas LLP, Debtor; Case No.: 16-13719-11, May 30, 2019.
[vii] Another, more commonly encountered intersection, involves the cancellation of indebtedness of a taxpayer in bankruptcy. IRC Sec. 108(b).
[viii] It is my understanding that many debtors will seek to liquidate under Chapter 11 because it enables their management team to remain in place and to “control” the liquidation process. Of course, a filing under Chapter 11 suspends all foreclosure actions.
[ix] Chapter 12 is designed for “family farmers” or “family fishermen” with “regular annual income.” It enables financially distressed family farmers and fishermen to propose and carry out a plan to repay all or part of their debts. Under chapter 12, debtors propose a repayment plan to make installments to creditors over three to five years. Generally, the plan must provide for payments over three years unless the court approves a longer period “for cause.”
[x] Reg. Sec. 301.7701-3.
[xi] By filing IRS Form 8832.
[xii] IRS Form 1065.
[xiii] IRC Sec. 701.
[xiv] IRC Sec. 1399. Special rules for individual bankruptcy cases are provided under IRC Sec. 1398.
[xv] By preventing the pass-through to the partners of the gain from the sale of Debtor’s assets
[xvi] In deference to the Court, I left the upper case “c” intact.
[xvii] Bankruptcy code Section 1129(b).
[xviii] Unless the seniors agree to subordinate some of their claims.
[xix] I.e., tax-paying.
[xx] Under which each of Debtor’s owners paid tax on their share of Debtor’s gains.
[xxi] Provided, of course, they had sufficient basis for their partnership interest. IRC Sec. 704(d). If losses were suspended because of insufficient basis, the gains from the sale of Debtor’s assets would have restored such basis and thereby allowed such losses to be utilized by the partners.
[xxii] Which is intended to provide its creditors with “adequate information” regarding the debtor to enable its creditors to make an informed judgement about the plan proffered. https://www.uscourts.gov/services-forms/bankruptcy/bankruptcy-basics/chapter-11-bankruptcy-basics
[xxiii] How about a partnership that becomes an S-corporation/association by filing IRC Form 2553, and that subsequently revokes its “S” election, thereby becoming an association taxable as a C-corporation?
[xxv] With the consent of its shareholders holding a majority of its stock. IRC Sec. 1362(d).
[xxvi] Compare this to the Debtor-partnership electing to become an association for tax purposes.
[xxvii] In general, the trustee may avoid any transfer of a debtor’s interest in property: (a) that was made within 2 years before the date of the filing of the petition if the debtor made such transfer with intent to hinder, delay, or defraud any entity to which the debtor was or became, on or after the date that such transfer was made, indebted; or (b) for which it received less than a reasonably equivalent value in exchange for such transfer; or was insolvent on the date that such transfer was made, or became insolvent as a result of such transfer.
[xxviii] Note the lower case “c”.
[xxix] Including (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.
[xxx] A corporation has little control over its S-corporation status, yet the right to exercise dominion and control over an interest is an essential characteristic defining property. Shareholders have the ability to control the tax status of their corporation. Election of S-corporation status may be achieved by one method: unanimous shareholder consent – the corporation does not elect S-corporation status. Thus, the Court concluded, any interest in electing S-corporation status belongs to the shareholders.
[xxxi] S-corporation status, it stated, is a statutory privilege that qualifying shareholders can elect in order to determine how income otherwise generated is to be taxed.
[xxxii] Especially when one considers the tax “benefit” of being able to claim the losses generated by the debtor-business.
Think about what a healthy business entity wants when considering the sale of its assets: one level of tax so as to maximize the net proceeds for its owners.