In re: The Majestic Star Casino, LLC, the United States Court of Appeals for the Third Circuit was faced with an issue of first impression in federal circuit courts of appeals: whether a corporate debtor’s tax status as a “qualified subsidiary” (QSub) is property of the corporation’s bankruptcy estate such that revocation of the status by the corporation’s non-debtor shareholder can be avoidable as an unauthorized post-petition transfer under Bankruptcy Code Sections 362, 549 and 550. The Court of Appeals held in the negative.
Majestic Star Casino II (MSC II) was a Delaware corporation and owner of a hotel and casino located in Indiana. MSC II was wholly owned by Barden Development, Inc. (“BDI”),1 whose sole shareholder was Don H. Barden (Barden). Prior to MSC II’s bankruptcy case, BDI had elected “small business” (S-corp) status under the Internal Revenue Code. BDI had further designated MSC II as QSub under the IRC. As a result of the designations, MSC II and BDI paid no taxes and received no tax benefits – all tax benefits and liabilities flowed directly to the shareholder of those entities, Barden.
In November of 2009, MSC II and certain of its affiliates (but not BDI or Barden) (the Debtors) filed voluntary chapter 11 petitions. In March 2010, after the petition date, Barden’s estate revoked BDI’s classification as an S-corp, which in turn terminated MSC II’s qualification as a QSub. As a result of the revocation, MSC II became liable for taxes for the entire tax year of 2010, an amount in excess of $2 million.
In March of 2011, the bankruptcy court confirmed the Debtors’ plan of reorganization, under which MSC II was converted to a limited liability company that was wholly owned by its former secured creditors and not Barden or BDI.
The Debtors (controlled by their former creditors) filed an adversary proceeding under 11 U.S.C. §§362, 549 and 550 against Barden’s estate,2 BDI and the IRS, seeking to avoid the termination and compel the reinstatement of MSC II’s status as a QSub. The Bankruptcy Court entered summary judgment in favor of the Debtors, directing the IRS to reinstate MSC II’s QSub status. The bankruptcy court’s holding was based largely on a line of cases holding that a debtor’s status as an S-corp is property of the debtor’s estate. The bankruptcy court found that the QSub status provided value to the debtor in the form of a “right” to be exempt from tax liability. This appeal followed.
The Third Circuit Court of Appeals reversed the bankruptcy court’s holding, finding that a debtor’s status as a QSub is not property of its estate that can form the basis of an avoidance action upon its termination. The Court focused on three common elements of void transfers under Section 362 and voidable transfers under Sections 549 and 550: the QSub status must be (1) property; (2) of the bankruptcy estate; (3) that has been transferred.
The Court of Appeals addressed only the first two elements, finding that, under either element, the Debtors’ argument failed. With respect to the first element – whether the QSub status was “property” – the Court found that it was not. In reaching this conclusion, the Court distinguished the “S-corp as property” cases, which applied the rationale underlying the rule that net operating losses (NOLs) are property of a debtor’s estate.3 The Court found that, unlike NOLs, a debtor’s status as an S-corp was neither quantifiable nor guaranteed – in fact, the mere existence of a company’s status as an S-corp is entirely dependent on factors outside of the debtor’s control. Unlike the NOLs, a company’s status as an S-corp may be terminated for any number of reasons – many of which are controlled by the shareholders of the corporation. The Court ultimately found that S-corp status is not property of the estate, and, by extension, neither is QSub status. A debtor has even less control of its QSub status than does an S-corp. In addition, the key elements of a “property interest” – alienability and assignability – are absent for QSub status.
The Court further held that status as a QSub (even if the status were a “property interest”) is not a property interest of MSC II’s bankruptcy estate, but rather a property interest of the QSub’s parent. By definition, a QSub is a “pass-through” entity who has no tax liability or benefits of its own; all tax benefits are owned by the QSub’s parent. For tax purposes, the QSub effectively does not exist.
Finally, the Court analyzed equitable circumstances that support a finding that the QSub status is not property of the estate. First, the Court of Appeals found that the Bankruptcy Court’s holding severely restricts the corporate parent’s right to terminate its S-corp status or a shareholder’s right to sell their stock or sell the company entirely. Any of those actions would terminate the QSub’s classification by operation of law. The Court also found that the relief of reinstating MSC II’s status as a QSub was inappropriate because it effectively gave MSC II a double recovery. Not only was MSC II free from tax liability (that would be borne by Barden’s estate entirely), but MSC II was able to reduce its liabilities through the bankruptcy without being liable for debt forgiveness income (therefore maintaining all of its applicable tax benefits in the future because it did not need to use the “Bankruptcy Exception”). All the while, Barden, the taxpayer, would receive no benefit from ownership of MSC II.
The Court finally addressed whether the Debtors have standing to pursue the avoidance claims. The Court found that, if the QSub status was property at all, it was not property of the Debtor MSC II; rather it was property of BDI or Barden. In that case, for the Debtors to have standing to pursue they claims, they must meet the requirements for third party standing. The court found that there were no grounds for third party standing in the case because there was no evidence that BDI or Barden were somehow unable to pursue these claims on their own behalf.
Majestic Star Casino is a significant opinion because the Court found that a “benefit” to a bankruptcy estate, alone, is not enough to make that benefit a “property right” that may be subject to avoidance under Sections 362, 549 or 550 of the Bankruptcy Code.
1 Although BDI is the ultimate owner of MSC II, MSC II was technically wholly owned by Majestic Star Casino, LLC, which was wholly owned by Majestic Holdco LLC, which was wholly owned by BDI.
2 Barden passed away during the bankruptcy case.
3 The Court was careful to point out that the Third Circuit has not addressed whether the “carry back” or “carry forward” of NOLs are property of the estate.