Under the Internal Revenue Code, a corporation can elect to be an “S” Corporation (“S-Corp”) for federal income tax purposes. Electing for S-Corp status will make the corporation a pass through entity, meaning that the corporation itself will not have any tax benefits or liability. Instead, the company’s income will be passed on to it shareholders, who will have to report it on their personal tax returns. Similarly, an S-Corp that owns a subsidiary corporation can elect to treat it as qualified subchapter S subsidiary (“QSub”). A QSub is also a pass through entity that passes its tax benefits and liabilities on to the parent corporation. S-Corp and QSub status may be revoked at any time with shareholder consent. In addition, these tax statuses can be automatically revoked when certain events occur, including the purchase of the corporation’s stock by more than 100 shareholders, purchase by a shareholder who is not a natural person or nonresident alien, or by the corporation’s issuance of more than one class of stock.
Recently, in In re Majestic Star Casino, LLC, the Court of Appeals for the Third Circuit held as a matter of first impression that a chapter 11 debtor’s status as a QSub for taxation purposes did not constitute “property” of the bankruptcy estate. Although other courts have ruled on the issue of S-Corp status as property of the estate, the Third Circuit was the first to decide the issue with respect to QSub status. Furthermore, the Third Circuit also questioned the prevailing logic that other courts had used when deciding that S-Corp statuses were property of the estate. As such, the non-debtor parent company’s revocation of its S-Corp status, which automatically revoked the debtor’s QSub status, did not constitute an avoidable post-petition transfer of property of the bankruptcy estate.
This Article is separated into three parts. Part I discusses the state of the law on this issue of whether S-Corp and QSub tax status are considered property of the bankruptcy estate prior to the Majestic Star Casino decision. Part II discusses the facts, holding, and reasoning of the Third Circuit in the Majestic Star Casino case. Part III discusses the practical effects of the decision.