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Saved By The S Election

Bankruptcy Court Holds S Corporation Status Is Not Property for Bankruptcy Purposes

A bankruptcy court, in a case of first impression in the Fourth Circuit, held that a Chapter 11 debtor’s S corporation status was not property for bankruptcy purposes and that the shareholders’ pre-petition revocation of the S election could therefore not be avoided as a fraudulent transfer. The court found that the debtor’s S corporation status lacked all of the attributes of a property right except for the right to use it to pass through tax liabilities to shareholders and that feature alone was not sufficient for the S election to be treated as a property interest. Health Diagnostic Laboratory, Inc. vs. U.S., 2017 PTC 543 (Bankr. E.D. Va. 2017).

Background

Health Diagnostic Laboratory, Inc. (HDL) was a clinical laboratory services company based in Richmond, Virginia. HDL tested blood samples it received from physicians for cardiovascular disease, diabetes, and other illnesses. HDL would reimburse the physicians for the costs associated with collecting, processing, and handling the blood samples.

In 2013, federal authorities began investigating HDL’s physician reimbursements as potential violations of federal anti-kickback laws. A fraud alert was released in 2014 advising that the payment of processing and handling fees to referring physicians could violate those laws. The fraud alert led to negative publicity and lawsuits against HDL. In April 2015, HDL agreed to a multimillion dollar settlement for alleged violations of the False Claims Act. By then, HDL’s relationship with its lender had become severely strained. HDL eventually defaulted on its loan and its borrowing ability was discontinued.

HDL filed a petition under Chapter 11 of the U.S. Bankruptcy Code in June 2015. In September 2015, a bankruptcy court entered an order authorizing the sale of substantially all of HDL’s assets. In May 2016, the court confirmed the plan of liquidation and a liquidating trust was formed.

HDL elected to be classified as an S corporation in 2009. That year, it entered into an agreement with its shareholders that required it to make distributions to reimburse shareholders for their passthrough tax liability. HDL remained an S corporation until January 2015, when the shareholders decided to terminate the S election and revert to C corporation status. As of the filing of the bankruptcy petition, HDL was a C corporation subject to C corporation tax.

In June 2017, the liquidating trustee filed a complaint against the IRS seeking to avoid the revocation of HDL’s S election as a fraudulent transfer. The government filed a motion to dismiss on the grounds that HDL’s tax status was not property for the purposes of the fraudulent transfer rules in Bankruptcy Code Secs. 544(b) and 548.

The trustee argued that HDL had a property interest in its S corporation status as a result of the 2009 shareholder agreement. According to the trustee, the agreement showed that HDL and its shareholders intended for the S election to forever bind the shareholders, and the trustee asserted that they breached their covenant of good faith and fair dealing by revoking the election.

If the revocation of the S election could be avoided, HDL would be retroactively classified as an S corporation and would file an amended return for 2015 showing losses. The losses would pass through to the shareholders, who would then file their own amended returns to apply the losses against any income they claimed in 2015, resulting in refunds. The trustee intended to demand those refunds from the shareholders for the benefit of the liquidating trust.

Analysis

The bankruptcy court noted that a split existed among the circuits on whether an S election is the property of an S corporation in bankruptcy. In In re Majestic Star Casino, LLC, 2013 PTC 109 (3d Cir. 2013), the Third Circuit Court held that S corporation status is not property for bankruptcy purposes because the definition of property under the bankruptcy statute, although broad, did not encompass S corporation status. The bankruptcy court noted that all of the other courts that have addressed the issue had found S corporation status to be a property right in bankruptcy and that there was no binding precedent in the Fourth Circuit.

The bankruptcy court adopted the Third Circuit’s reasoning in Majestic Star Casino in holding that HDL’s S election was not property and that there was therefore no transfer that could be avoided under the fraudulent transfer rules. The court found that, under Fourth Circuit precedent, an interest constitutes property for federal tax purposes if it embodies essential property rights, which include (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 extent to which the taxpayer can control the use of the property; (5) whether the purported property right is valuable; and (6) whether the purported right is transferable.

Applying these factors, the bankruptcy court determined that only one factor – HDL’s right to use its S corporation status to pass its tax liability through to its shareholders – leaned in favor of treating the S status as property. However, the court noted that the right to use is the weakest of the property rights’ factors because it fails to meaningfully denote ownership without the rights of control and disposition. HDL may have had the right to use its S corporation status, the court said, but it lacked the ability to control the use of its tax classification, and the right to use the classification existed only until it was terminated.

The court found that HDL’s tax classification was valuable but did not support a finding of a property right. The court agreed that the trustee’s intention to collect shareholders’ tax refunds in order to maximize returns to creditors could, if successful, create value for the estate. However, the court concluded that this value alone did not create a property right. Moreover, the court reasoned, Congress intended S corporation status to be of value to shareholders, not to the corporation.

The court concluded that the remaining factors also favored a finding that S corporation status does not constitute a property right under federal tax law. According to the court, the right to exercise control over an interest is an essential characteristic and HDL had very little control over its S corporation status. As the court pointed out, shareholders have the overwhelming ability to control a corporation’s tax status because the only permitted method of making an S election is a unanimous vote by the shareholders. Further, the corporation has no unilateral control over any of the events that cause the termination of S corporation status. In the court’s view, the fact that the S corporation itself must file an IRS form to implement the shareholders’ decision does not confer control over the S election.

 

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