"Tax Attributes" that shield in opposition to income taxes as "property"

Many small businesses are structured as pass-through businesses for federal income tax purposes. (1) Well-known examples include partnerships, limited liability companies, and companies that choose “S Corporation” status from among 26 US states. § 1362. (2)

When a business fails, its bills exceed the cash available. If these invoices are not deductible for income tax purposes (e.g., repaying debt or paying installments on non-depreciable real estate (3)), the company may incur income tax liabilities with no cash available to meet those liabilities. If the company is a pass-through and is not generating enough cash to pay its tax liabilities, it may be the owner of the company who has tax liabilities and no cash to pay off those tax liabilities. Many business owners see this danger and try to avoid the unfunded tax liabilities that arise from doing business. Often the plan is to eliminate the company's pass-through status, leaving tax liabilities to the failing company. This plan is especially attractive when the business owner has determined that the business will fail, whether or not it is burdened with the tax liability.

A common way for business owners to remove a company's pass-through status is to destroy a company's qualification for S Corporation status. Often this is done by transferring a small stake in the company to a prohibited shareholder. See 26 U.S.C. Section 1361 and related provisions. This pattern of facts is exactly what happened prior to filing for bankruptcy pending decision at In re GYPC, Inc., S.D. Ohio Bankr. Case No. 17-31030; Harker, Trustee v Cummins et al., S.D. Ohio Bankr. Adv. Proc. 19-3046 (August 5, 2020).

In GYPC, the trustee brought preferential and fraudulent promotion claims against the company's clients. In part, these allegations were based on the idea that GYPC's status as S Corporation was a "property interest" and that GYPC's loss of S Corporation status was a transfer of property that could be an invalid preference for a fraudulent transfer. In fact, there can be no doubt that GYPC's status as an S-Corporation protected the company from income tax liability. (4)

The GYPC court first looked at whether the S Corporation's status was a property interest and first looked at whether state, tax, or bankruptcy law controlled that issue. After recognizing the general rule that a bankrupt debtor's property interests are determined by state law, the GYPC court said the following:

The property of the estate includes “all legal and reasonable interests of the debtor in the property at the beginning of the proceedings”. 11 U.S.C. Section 541 (a) (1). Property is broadly defined to include various amounts of intangible property. Of course, filing for bankruptcy does not extend property rights and, in general, state law defines property rights. Butner v USA, 440, US 48, 56 (1979). In the context of tax law The Internal Revenue Code does not create property rights, but "brings nationwide defined consequences with rights created under state law." United States v Bess, 357, US 51, 55 (1958). However, once state law determines an interest – in this case, a valid Delaware S corporation – "the tax consequences will be determined by federal law from now on." Aquilino v USA, 363, US 509, 513 (1960). See also Arrowsmith v USA (In re Health Diagnostic Lab., Inc.), 578 B.R. 563 (Bankr. ED Va. 2017) ("State law has created" sufficient interests "in the taxpayer by giving him the necessary corporate and shareholder attributes to qualify for S company status (.)" ). The Supreme Court concluded that federal law determines whether a taxpayer has an economic interest in taxable property. Drye v USA, 528, US 49, 57 (1999). The bankruptcy code itself recognizes that the Internal Revenue Code regulates whether a bankruptcy estate is taxable separately from the debtor. 11 U.S.C. Section 346 (a). See In re Majestic Star Casino, LLC v Barden Dev & # 39; t (In re Majestic Star Casino, LLC), 716 F.2d 736, 751-52 (3d Cir. 2013) (Conclusion of the Internal Revenue Code, non-state law , "Governs the characterization of the tax status of a company as a property interest within the meaning of the Insolvency Act.")

(Emphasis added).

The GYPC court then looked at previous rulings in other jurisdictions directly relating to whether the cancellation of a company's S corporation status and tax liability protection was the transfer of "ownership" that was a preference for a fraudulent one Could be transmission. The GYPC court found a division of powers, saying:

The Third Circle took a contrary view from a number of previous decisions and found that such a transfer was not a recoverable property interest. Majestic Star Casino, 716 F.3d, 763 (Conclusion that the corporate status of a sub-chapter S is not a property interest). Another recent decision that a change in corporate status is not a property interest is Arrowsmith v. United States (In re Health Diagnostic Lab., Inc.), 578 B.R. 552 (Bankr. E. D. Va. 2017). See also Rights of Berit Galesi Shareholders in Relation to Termination of Debtor Company Status in Insolvency Proceedings, 10 J. Bankr. L. & Prac. (Jan./Feb. 2001) (Criticism of the theory that a change in the tax status of an S Corporation is a fraudulent transfer). Perhaps the leading case taking the opposite view is In re Trans-Lines West, Inc., 203 B.R. 653 (Bankr. E. D. Tenn. 1996),. . See also Halverson v Funaro (In re Funaro, Inc.), 263 B.R. 892, 898 (BAP 8th Cir. 2001) (citing Parker v Saunders (In re Bakersfield Westar, Inc.), 226 BR 227, 232-33 (BAP 9th Cir. 1998)) (“(A) Company's right of use , benefit from or revoke its status in sub-chapter S falls under the broad definition of ownership of the estate. ").

Following this discussion, the GYPC court decided to follow the cases in which it was found that S corporation status is not a property interest that can be subject to a potentially null and void transfer by the company.

The GYPC court agreed with the reasoning of the courts, which ruled that status is not a “property right” of the company because a company's shareholders, not the corporate entity, control the choice of S Corporation. In particular, the GYPC court said: “(t) The estate lacks the ability to control or dispose of the status of an S company under federal tax law. This right can only be exercised through the election of the shareholders and therefore lies with the shareholders and not with the company. “Later the GYPC court ruled:

Outside of bankruptcy, it would never be understood that a company could force an S company to transform into a Type C company. The rights to be an S company are strictly defined and benefit the shareholders who are entitled to such company status. Bankruptcy cannot expand property rights and transfer control of the corporate status of Subchapter S to a trustee who deviates from federal tax law. Health Diagnostic, 578 B.R. at 570 ("The Liquidating Trustee cannot use the fraudulent remittance provisions of the Bankruptcy Act to circumvent the stringent requirements of the Tax Code.") For these reasons, the claim that GYPC's conversion from a Sub-S company to a C – Society is a preferential or fraudulent transfer.

Certain “tax attributes” of bankrupt companies are indeed owned and subject to a preference or fraudulent promotion complaint if a transfer has been involved. This is especially important for tax attributes that provide tax benefits. One example is Net Operating Losses (NOLs), which, like the status of S Corporation, can protect a company from liability for income taxes. In several instances, it is found that NOLs (and the tax protection they provide) are “owned” by the entity that caused the losses and that a waiver of NOLs may be a fraudulent transmission. See Harker v. IRS (In re Citro), Case No. 16-32161, Adv. No. 18-3008, doc. 32 (Banker S. D. Ohio, Aug. 30, 2018) and other cases cited in the GYPC ruling.

The GYPC decision and the supplementary decisions regarding NOLs have the same rationale. The GYPC court relied on the NOL-related decisions when choosing between the conflicting previous decisions regarding the status of the S Corporation discussed above: Since the company that created the NOL, the use of those losses and the resulting tax benefit controlled, the NOL are owned by the company and, conversely, the status of S Corporation is not owned by the company as a company cannot control the choice of S Corporation. See In re Health Diagnostics Laboratory, Inc., 578 B.R. 552, 568-9 (E. D. Bankr. Va. 2017), where the court found:

. . . (S Corporation Status) is very different from a company's net operating loss (“NOL”). NOLs have several “material property rights” that are absent from S corporation status. . . . First, a taxpayer company has the right to exclude others from an NOL while a company cannot exclude others from using S corporation status. Second, the taxpayer (business entity) has much more control over an NOL than over the status of an S-company. NOLs cannot be revoked or terminated by any other party, as opposed to S company status, which can be terminated by shareholder action that will result in the company ceasing to be considered a small business. . . . Third, a NOL is transferable to other companies, while the status of an S company cannot be transferred. See e.g. B. In re A. H. Robins Co., 251 B. R. 312, 315, 320-21 (Maintaining the validity of a confirmation order by which NOLs were transferred from the debtor to a successor company).

With that analysis in mind, it could predict how bankruptcy courts will uncover similar questions about other tax attributes that protect debtor companies from income tax liabilities – such as historical tax credits. A less extensive search did not find any specific bankruptcy proceedings, but there are several instances where historical tax transferable credits are owned and therefore transferring those tax credits is a taxable sale. A representative example is the Virginia Historic Tax Credit Fund 2001 LP v. Commissioner, 639 F.3d 129 (3d Cir. 2011) (tax credits were "owned" and their transfer was a "disguised sale" under federal tax law). The court's reasoning in this case is very similar to the reasoning discussed above about who controlled the right to enjoy and maintain the tax benefits of the tax attribute in question. After warning that property tax credits have not been checked in all situations (5), the Virginia Historic Tax Credit Fund LP court said in 2001:

Therefore, to determine if the historic Virginia rehabilitation tax credits for federal tax purposes are "property," we ask if they embody "some of the most important property rights." . . . In particular, the Supreme Court of Crafts has identified the "right to use property, receive income from it and exclude others from it" as fundamental property rights. I would. Similarly, the Drye Supreme Court emphasized "the breadth of control taxpayers can exercise over property." and whether the right in question was "valuable". (internal markings and quotations omitted). 528 U.S. at 60-61, 120 S.Ct. 474 … .

From these facts it appears that the funds' tax credits were both "valuable" and imbued with "some of the most important property rights". . . . The funds' tax credits had financial value. This is evidenced by the fact that the funds used the credits to get investors to contribute money. Additionally, The funds could exclude others from using the loans and were free to keep the credits or give them to partners as they saw fit.

I would. At 141 (emphasis added).

If a bankruptcy court were to adopt the reasoning of the Virginia Historic Tax Credit Fund 2001 LP v Commissioner, 639 F.3d 129 (3d Cir. 2011) and similar cases, it would mean that a bankruptcy court could invalidate tax credits as should fraudulent promotion preferences the transferor file for bankruptcy.

Certain other potentially important legal ramifications result from the inference that certain tax attributes are "owned". For example, there may be an insurable interest in the property and loss of or damage to property may be actionable in tort. After all, property can be stolen.

Knowing what you own is always important.