Pursuant to Section 541(a) of Title 11 of the U.S. Code (the Bankruptcy Code), the filing of a bankruptcy petition creates an estate composed of "all legal or equitable interests of the debtor in property as of the commencement of the case." The term "property of the estate" has been broadly construed to include tangible or intangible property in which the debtor has an interest at the time it seeks bankruptcy protection. (See, e.g., In re Kane, 628 F.3d 631, 637 (3d Cir. 2010).) On May 21, the U.S. Court of Appeals for the Third Circuit in Majestic Star Casino LLC v. Barden Development (In re Majestic Star Casino LLC), Case Nos. 12-3200 and 12-3201 (3d Cir. 2013), determined that the broad scope of § 541(a) did not include a debtor corporation's status as an S corporation under the Internal Revenue Code. Though a matter of first impression before the circuit court, the decision marks a departure from a line of lower and appellate court decisions that have held a debtor's tax status to be property of the debtor's bankruptcy estate. (See, e.g., In re Trans-Lines West, 203 B.R. 653 (Bankr. E.D. Tenn. 1996).)

In Majestic Star Casino, the Third Circuit was presented with the specific question of whether a nondebtor company's decision to abandon its classification as an S corp is void as a post-petition transfer of property of the bankruptcy estate or is avoidable under §§ 362 or 549 of the Bankruptcy Code. At the time of the debtors' bankruptcy filings, Majestic Star Casino II Inc. (MSC) owned and operated a hotel and casino in Indiana. MSC was wholly owned by Barden Development Inc. (BDI), which in turn was wholly owned by Don H. Barden. Before the bankruptcy, BDI qualified as a "small business corporation" under § 1361(b) of the Internal Revenue Code and had elected to be treated as an S corp for federal income tax purposes. As an S corp, BDI was not subject to federal taxation or state taxation; rather, its income and losses were passed through to Barden, who was required to report BDI's income on his individual tax returns. Similarly, pursuant to § 1361(b)(3)(B) of the Internal Revenue Code, BDI elected to treat MSC as a "qualified subchapter S subsidiary" (QSub), which "meant that MSC was not treated as a separate tax entity from BDI, but rather that all of its assets, liabilities, and income were treated for federal tax purposes as the assets, liabilities and income of BDI," the opinion said. As a result, MSC paid no federal taxes.

After the bankruptcy filing, Barden effectuated the revocation of BDI's S corp status. As a result, MSC's status as a QSub was automatically terminated because it no longer met the requirement that it be wholly owned by an S corp. (See Internal Revenue Code § 1361(b)(3)(B).) MSC thus "became responsible for filing its own tax returns and paying income taxes on its holdings and operations," the opinion said.

On December 31, 2010, MSC and related debtors filed an adversary complaint against, among others, Barden and the Internal Revenue Service. They alleged that Barden's revocation of BDI's S corp status caused an unlawful post-petition transfer of property of MSC's bankruptcy estate in violation of, inter alia, § 362(a)(3) of the Bankruptcy Code, which stays any act to exercise control over property of a debtor's bankruptcy estate. The debtors demanded an order directing the IRS "to restore BDI's status as an S corp and MSC II's status as a QSub," the opinion said.

The IRS moved to dismiss the complaint on the grounds that MSC's status as a QSub was not "property" of its estate and that no "transfer" of property occurred when BDI terminated its own S corp election. Barden answered the complaint and moved for judgment on the pleadings, contending "that because a QSub has no separate tax existence, [MSC] had no cognizable property interest in that status," the opinion said. Barden further argued that "because a subsidiary's QSub status depends entirely on elections made by its S corp parent, even if [MSC's] QSub status were a species of property, it was property that belonged to BDI and Barden." On MSC's motion for summary judgment, the bankruptcy court held that "MSC II's status as a QSub was the property of MSC II, and that, as such, it belonged to MSC II's bankruptcy estate." The case was thereafter certified for direct appeal to the circuit court.

On appeal, the Third Circuit vacated the bankruptcy court's order and remanded the matter with directions to dismiss the complaint. The Third Circuit disagreed with the bankruptcy court's reliance on the series of cases beginning with Trans-Lines West, which considered whether a corporation's revocation of its S corp status prior to filing for bankruptcy was an avoidable prepetition transfer of property. The bankruptcy court in Trans-Lines West concluded that the debtor "possessed a property interest in its subchapter S status" because the debtor had a guaranteed right to use, enjoy and dispose of such interest as provided under the Internal Revenue Code. (See In re Funaro, 263 B.R. 892, 898 (B.A.P. 8th Cir. 2001) ("A corporation's right to use, benefit from, or revoke its subchapter S status falls within the broad definition of property"); In re Bakersfield Westar, 226 B.R. 227, 234 (B.A.P. 9th Cir. 1998) (holding that Trans-Lines West "is consistent with the Ninth Circuit's definition of property").)

The Third Circuit distinguished the conclusions reached in Trans-Lines West and its progeny, noting that those cases based their conclusions on a series of precedents in which it was held that net operating losses (NOLs) were property of a debtor's bankruptcy estate. Specifically, those courts have recognized that "the right to offset NOLs against past income (a 'loss carryback') is property of an individual debtor, because it entitles the debtor to a refund of taxes already paid." (See, e.g., Segal v. Rochelle, 382 U.S. 375, 380-81 (1966).) Subsequent cases extended this principle to allow for the use of NOLs to offset future tax liability (a "loss carryforward"). (See, e.g., In re Prudential Lines, 928 F.2d 565, 567 (2d Cir. 1991).) As the circuit court described, the Trans-Lines West cases then extended this logic, "saying that the ability to make an S corp election, like the ability to elect whether to carry forward or carry back NOLs, is property."

Declining to follow this reasoning, the Third Circuit distinguished an entity's interest in its designation as an S corp from its interest in NOL offsets. Primarily, the circuit court reasoned that, unlike NOLs, an entity's tax status is entirely contingent on the will of its shareholders. Moreover, the court recognized that the Internal Revenue Code "does not, and cannot, guarantee a corporation's right to S corp status, because the corporation's shareholders may elect to revoke that status 'at will' pursuant to § 1362(d)(1)(B)." Finally, the court concluded that even if MSC's tax status could be considered "property" at all, such property belonged to BDI as MSC's parent because "a QSub's use and enjoyment of its tax status may be terminated by factors not only outside its control, but outside the control of its S corp parent." The court reasoned that a contrary holding would "place remarkable restrictions on the rights of the parent" to alter or terminate its own tax status, restrictions that lack foundation in both the Internal Revenue Code and the Bankruptcy Code. Section 541 of the Bankruptcy Code is generally construed very broadly to encompass all types of property in which the debtor has any interest. There are limits to this principle, however, and the decision in Majestic Star Casino underscores the point that an attenuated interest over which the debtor has no control, and that can be summarily taken from the debtor at the discretion of a third party, may be excluded from the debtor's estate. •

Rudolph J. Di Massa Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors' rights.

Jarret P. Hitchings is an associate in the firm's Wilmington, Del., office and practices in the area of business reorganization and financial restructuring.