Volatile Windfalls: Effects of Tax Cuts and Jobs Act for S-corp Shareholders Warrant Strong Arm Power Limitation in Bankruptcy

• Publication year: 2020

Volatile Windfalls: Effects of Tax Cuts and Jobs Act for S-Corp Shareholders Warrant Strong Arm Power Limitation in Bankruptcy

Jack M. Dougherty

VOLATILE WINDFALLS: EFFECTS OF TAX CUTS AND JOBS ACT FOR S-CORP SHAREHOLDERS WARRANT STRONG ARM POWER LIMITATION IN BANKRUPTCY

Abstract

For years, a nuanced judicial inconsistency at the intersection of the U.S. Internal Revenue and Bankruptcy Codes has percolated in bankruptcy and appellate courts, generating a judicial split and erratic outcomes for a small few of the approximately 4 million S corporations in the United States. The split concerns whether S corporation shareholder termination rights granted under § 1362 of the Tax Code constitute avoidable fraudulent transfers under § 548 of the Bankruptcy Code.

Some courts, including those in In re Trans-Lines West, Inc. and In re Bakersfield Westar, Inc., have historically permitted bankruptcy trustees to unilaterally shift the capital gains liabilities stemming from asset liquidation sales of insolvent S corporations to third parties—the business's shareholders—who are not parties to the bankruptcy proceeding, characterizing the terminations as 'fraudulent conveyances.' Recently, however, two courts, including the Third Circuit in In re Majestic Star Casino, LLC and a Fourth Circuit Bankruptcy Court in In re Health Diagnostic Lab. Inc. have restricted the liquidating trustee's nearly unlimited strong arm power to avoid S election terminations, creating inconsistent treatment in federal bankruptcy courts.

This Comment begins with a background discussion of the relevant sections of the two federal codes involved in the judicial uncertainty at issue. Second, this Comment considers potential implications of the Tax Cuts and Jobs Act on S corporation shareholders, which is likely to increase the frequency of litigation over Subchapter S elections and termination rights in the context of the Strong-Arm power. Ultimately, this Comment suggests that, at the intersection of the Tax and Bankruptcy Codes, there lies a strong argument for creating an exception to the fraudulent conveyance doctrine for S corporations.

[Page 300]

Introduction

This Comment suggests that the enactment of Public Law 115-97 (Tax Cuts and Jobs Act),¹ first applicable for individual filer's tax returns for fiscal year 2018,² incentivizes a statistically significant number of the owners of over 4 million S corporations in the United States to convert their businesses into other business forms.³ According to the Internal Revenue Service, "S corporations became the most common corporate entity type in 1997," and "continue to be the most prevalent type of corporation."⁴ While the Tax Cuts and Jobs Act directly amended the Internal Revenue Code, its effects in bankruptcy courts are complicated. In particular, the Act impacts the scope of the fraudulent conveyance doctrine under the Bankruptcy Code.

Under 11 U.S.C. (Bankruptcy Code)⁵ § 548 (Strong Arm power),⁶ liquidating trustees possess nearly unlimited power to avoid fraudulent transfers of property or interests of the debtor in property made by debtors prior to filing for bankruptcy protection.⁷ While some scholars have noted several solutions to an "issue [arising] at the intersection of federal bankruptcy and tax law" may warrant the creation of a Strong Arm clause exception,⁸ courts have recently begun to adopt those suggestions, creating judicial uncertainty.⁹ The uncertainty

[Page 301]

at issue, most recently addressed in Health Diagnostic Lab., Inc. v. United States (In re Health Diagnostic Lab. Inc.),¹⁰ concerns whether termination of 26 U.S.C. (Tax Code) § 1361¹¹ small business corporation (S corporation) shareholder elections under § 1362 constitute avoidable fraudulent transfers under the Strong Arm power.¹² Recently, two courts restricted the liquidating trustee's nearly unlimited Strong Arm power to avoid S election terminations,¹³ creating inconsistent treatment in federal bankruptcy courts with the potential to morph into a full blown circuit split.¹⁴

While relatively few opinions directly address the judicial uncertainty discussed in this Comment, the courts and scholars who have considered the issue sharply disagree on nuanced issues of statutory interpretation, competing policy goals, and ultimately whether shareholders or the bankruptcy estate ought to shoulder the capital gains burden arising from an S corporation's asset liquidation. This Comment suggests that the enactment of the Tax Cuts and Jobs Act¹⁵ is likely to increase the frequency of litigation over Subchapter S elections and termination rights in the context of the Strong Arm power.¹⁶ This Comment examines prior holdings that have addressed the issue in light of the Tax Cuts and Jobs Act's potential impact on shareholders of S corporations moving forward.

The following illustration, articulated by tax scholar Richard Shaw in Taxing Shareholders on the Income of an S Corporation in Bankruptcy, distinguishes

[Page 302]

the competing treatment of S corporation tax elections as either protected or avoidable property interests in bankruptcy:

The only asset of Corporation X, an S corporation, is Blackacre, which is raw land with a basis of $1 million and a fair market value of $2 million. X has two shareholders, A and B. X is in financial straits and is about to file a voluntary petition in bankruptcy to stave off its creditors. If X retains its status as an S corporation after going into bankruptcy, the trustee may force a sale of Blackacre for $2 million and apply the entire proceeds to satisfy the claims of creditors. Since X is an S corporation, recognized gain from the sale is not subject to tax at the corporate level. Instead, the gain recognized by the corporation passes through and will be taxed to A and B under IRC Section 1366. Since Subchapter S has shifted the tax obligation from the corporation to its shareholders, the federal tax resulting from the sale of Blackacre by the corporation will not be an obligation of the bankruptcy estate, and would not be paid as a first priority administrative expense of the estate under Bankruptcy Code Sections 503(a)(1)(B) and 507(a)(1). The unfortunate effect for the shareholders is that the $2 million proceeds from the sale have been severed for the benefit of creditors and are not made available to satisfy the $200,000 federal tax burden inherent in the recognized gain.¹⁷

Notably, in Majestic Star Casino, LLC v. Barden Dev., Inc. (In re Majestic Star Casino, LLC), the Third Circuit recently found that permitting such unfortunate burden shifting of tax liability to S corporation shareholders was based on incorrect logic and contradicted multiple bankruptcy policy goals.¹⁸ The In re Health Diagnostic Lab., Inc. court tended to agree, asserting that "[t]he Liquidating Trustee cannot hold the shareholders 'tax hostage' by avoiding their decision to revoke the S corporation election."¹⁹ While the In re Majestic Star Casino, LLC and In re Health Diagnostic Lab., Inc. decisions create outcomes equitable to both creditors and the S corporation's shareholders, they each rest on a number of contested statutory interpretation and policy issues which, as discussed later in this Comment, remain unresolved.

This Comment begins with a background discussion of the relevant sections of the two federal codes involved in the judicial uncertainty at issue. First, it

[Page 303]

discusses the Tax Code, followed by a discussion of the related Bankruptcy Code sections in question and their relationship to the Tax Code. Next, this Comment analyzes statutory interpretation issues and a number of related conflicting Tax and Bankruptcy Code policy questions raised by courts, scholars, and experts. This Comment then considers potential implications of the Tax Cuts and Jobs Act on S corporation shareholders, which raises additional questions regarding previous court decisions.²⁰ Indeed, the specific effects of the Tax Cuts and Jobs Act on S corporations and their shareholders highlight policy considerations raised on both sides of this judicial uncertainty. Finally, this Comment considers whether the implementation of the Tax Cuts and Jobs Act will cause more litigation in this area in the near future, and suggests that judicial and legislative creation of a Tax Code § 1362 exception to the Bankruptcy Code Strong Arm power for S corporation election rights provides an equitable solution for both shareholders and creditors.²¹ In addition, the In re Health Diagnostic Lab., Inc. court's examination of the issue in light of tax-specific statutory interpretation also increases its analytical value for future courts that may encounter the issue, for many of whom the question will be an issue of first impression.²² Ultimately, these policy considerations support the conclusion that S elections pose unique challenges which should thus be excepted from the Strong Arm power under the Bankruptcy Code.

I. Statutory Background and Legal Doctrine

A. 26 U.S.C. §1361-62: The S Corporation—Overview

There are fundamental Tax Code differences between two types of corporations, C corporations²³ and § 1362 S corporations, relevant to the judicial uncertainty concerning S corporation insolvencies discussed in this Comment. The shareholders of C corporation business entities are generally not liable for the business's debts in bankruptcy.²⁴ The "default"²⁵ "C corporation" business

[Page 304]

structure refers to corporations generally,²⁶ and is subject to double taxation under the Internal Revenue Code: first at the corporate level as a tax-paying entity separate from its shareholders, and then again at the shareholder level as dividends distributed to its shareholders.²⁷ Although subject to double taxation, the C corporation generally shields the corporate entity's shareholders from exposure to personal liability for the entity's debts in bankruptcy²⁸ —that is to say that the business is a distinct legal entity from its owners...