Status Check: Should the Federal Tax Status of a Disregarded Debtor Be Property of the Estate?

• Publication year: 2023

Status Check: Should the Federal Tax Status of a Disregarded Debtor Be Property of the Estate?

J. Benjamin Ward

STATUS CHECK: SHOULD THE FEDERAL TAX STATUS OF A DISREGARDED DEBTOR BE PROPERTY OF THE ESTATE?

Abstract

This Comment focuses on whether the tax status of a debtor constitutes "property" of the debtor's estate under 11 U.S.C. § 541(a). The answer to this question ultimately determines whether a bankruptcy trustee has the power to avoid a "check-the-box " tax status change made by the owner of a debtor entity from a "pass-through" to a separately taxed C Corporation. This issue normally arises when the parent corporation or individual owner of a debtor subsidiary corporation or disregarded entity (to the individual owner) elects to transform the status of the debtor by "checking the box" on the proper federal tax form.

This Comment utilizes a hypothetical scenario involving an individual who owns a pass-through entity which holds a completely depreciated piece of real property. The individual decides to leverage the piece of real property but, through a series of misfortunes, is subsequently forced to place the entity holding that real property into bankruptcy. In bankruptcy, the distressed property is sold in a forced sale that is a taxable event. The individual owner of the debtor entity is motivated to make a prepetition or post-petition tax status change in entity type to a C Corp because the tax obligation resulting from the gain on sale of the real estate no longer "passes through" to the owner's tax return once the change is made. Instead, the tax gain remains with the newly-transformed C Corp and the bankruptcy estate. In effect, the change in tax status allows the owner of a debtor entity to shift the tax burden normally flowing to the owner as a pass-through gain to instead be paid by the bankruptcy estate simply by making a change on a tax form. Check-the-box changes can also tangibly affect other kinds of tax attributes, such as the ability to use NOLs.

Courts are split on whether the debtor entity's tax status constitutes property. This Comment advocates for the position taken by the Third Circuit, that ultimate control of the debtor's tax status is contingent on the will of the parent-owner of the debtor and is therefore, not property. This Comment argues against courts within the Sixth and Ninth Circuits, which have held that tax attributes of a debtor are property of the debtor's estate protected by the automatic stay under 11 U.S.C. § 362(a) and are therefore subject to the trustee's avoidance powers under sections 544, 548, and 549 of the Bankruptcy Code.

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Table of Contents

Introduction..........................................................................................631

I. Scenario & Background Law...................................................637

A. Three Potential Buddies: Choosing Between an SMLLC, a C Corp, and an S Corp ........................................................... 637

B. Buddy LLC in Distress: The Capitol Hill Land Purchase ......... 639

C. Buddy in Bankruptcy............................................................... 641

D. Checking the Box.................................................................... 645

E. Fraudulent Transfer & Avoidance Powers .............................. 646

II. Property of the Estate in Bankruptcy....................................648

A. Section 541 and the Text of the Bankruptcy Code .................... 648

B. The Burner Principle: Looking to State Law............................ 650

C. Chicago Board of Trade: Intangible Rights ............................. 651

III. The Disfavored Approach and the Favored Approach.........652

A. The Disfavored Approach ....................................................... 653

1. In re Trans-Lines West and In re Bakersfield Westar......... 654

2. The NOL Cases ................................................................. 658

B. The Favored Approach ........................................................... 663

1. In re Majestic Star Casino, LLC ........................................ 663

2. A Continuation of the Move in the Right Direction: In re Health Diagnostic Laboratory ................................... 667

3. Why It Matters: The Fresh Start Policy ............................. 670

4. An Exceedingly Simple Solution ........................................ 673

Conclusion.............................................................................................674

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Introduction

For at least the last century, bankruptcy and other federal courts have struggled to define what qualifies as "property" under section 541 of the Bankruptcy Code.¹ The Supreme Court determined that Congress declined to provide a complete definition of the term specifically to enable a bankruptcy trustee to draw as many of a debtor's rights and interests as possible into the bankruptcy estate² —because a larger estate benefits the debtor's creditors. As the congressional record to section 541 details, legislators envisioned "property" as "includ[ing] . . . all interests such as . . . contingent and future interests."³ Under such a broad definition, section 541 empowers a trustee to rake a comprehensive array of a debtor's property rights into the estate, leading to a more thorough distribution of the debtor's assets.⁴ Though a debtor is unlikely to enjoy a trustee turning over every proverbial stone to locate valuable property rights, this sometimes-invasive process allows the debtor to walk away from the bankruptcy proceedings with a cleaner and more thorough fresh start at discharge, because a greater number of assets with monetary value will be available to settle outstanding debts.

However, there are logical limits to what should be brought under the definition of property. Despite congressional intent, issues arise when a trustee attempts to draw exotic property interests into the estate, especially those interests that are difficult to administer because they are novel, uncommon, and hard to value.⁵ one area in which courts struggle to reach a concrete definition for the word "property" is where the Bankruptcy Code intersects with the Internal Revenue Code (the "IRC") concerning the "tax attributes" derived from the IRC, specifically the tax status of an entity.⁶ Friction exists at this

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intersection because the term "property" for purposes of the Bankruptcy Code does not mean, at every instance, the same thing as it does for the IRC.⁷

Specifically, courts have developed two major approaches to help determine whether a certain tax attribute of a taxpayer, that of tax status, is considered "property" of the bankruptcy estate under section 541(a). The approach adopted by a given court ultimately determines the ability of a bankruptcy trustee to use its avoidance powers under sections 544, 548, and 549 of the Bankruptcy Code. These avoidance powers permit the trustee to reverse a modification of the debtor entity's tax status outside of the bankruptcy process.⁸ Courts are split on whether to characterize the modification to tax status as an allegedly fraudulently transfer of "property" out of the bankruptcy estate.⁹

The first approach, adopted by the Ninth Circuit's Bankruptcy Appellate Panel and the Bankruptcy Court for the Eastern District of Tennessee, among others,¹⁰ has its roots in a line of net operating loss ("NOL") cases out of the Second, Eighth, and Ninth Circuit Courts of Appeals.¹¹ This approach considers tax status to be "property" of the bankruptcy estate by embracing an all-encompassing definition of the term. The primary reason these courts consider tax status to be property of the bankruptcy estate is that a non-debtor taxpayer's tax attributes can be so "intertwined with that of a bankrupt debtor [that allowing a taxpayer to manipulate the tax attribute in question] would have the legal effect of diminishing or eliminating property of the bankrupt estate."¹² The practical effect of including tax status in the definition of property is that non-debtor taxpayers who own entities undergoing bankruptcy are barred by the Bankruptcy Code from arranging their tax affairs in a manner prescribed by the IRC. If a

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non-debtor owner attempts to manipulate the debtor's tax status in such a manner, the owner is found to have committed a transfer reversible by the trustee's avoidance powers, and faces revocation of these otherwise lawful actions concerning the tax status.¹³ Revocation leads to cascading negative consequences which cut directly against "the principal purpose of the Bankruptcy Code,"—namely, "to grant a fresh start" to the debtor.¹⁴

Though judges who employ this approach may have good intentions in attempting to realize one of the goals of bankruptcy (an equitable distribution of property to creditors), their approach is nonetheless mistaken. The approach accomplishes this goal, but at the cost of creating judge-made rules that unjustifiably cram an increasing number of tax attributes into the definition of property. In so doing, these courts show a lack of careful consideration of the juxtaposition of the IRC with the Bankruptcy Code, creating real inequities for debtors. These tax status cases also extrapolate from the shallow logic of cases that have reckoned NOLs as property of the estate, thereby creating a dangerous precedent that could allow future courts to glom onto such logic to extend "property of the estate" to encompass other tax attributes. This wrongheaded approach endangers bankruptcy's promise of a fresh start by taking tax liabilities (such as those arising from foreclosure sales of real property occurring before or during bankruptcy from the debtor's estate) and forcing them upon the non-debtor owners of the troubled entities.¹⁵ This reassignment undercuts the IRC, which explicitly allows for tax status changes at the will of the owner.¹⁶ In these jurisdictions, there is no true "discharge" of the respective...