Definition of Property Limited Under Bankruptcy Code

On March 28, 2012, we wrote about a bankruptcy court decision voiding a nondebtor parent company’s revocation of its own S corporation status, which had the effect of terminating its debtor subsidiary’s “qualified Subchapter S subsidiary” (QSub) status, as an unlawful transfer of the debtor subsidiary’s property in violation of Sections 362 and 549 of the Bankruptcy Code. The decision in The Majestic Star Casino LLC v. Barden Development (In re The Majestic Star Casino LLC), Adv. No. 10-56238 (Bankr. D. Del. Jan. 24, 2012), was noteworthy for its expansive view of what constituted property of the debtor’s estate and its holding that the debtor’s QSub status was a property interest of the estate since it afforded the debtor the right to be free of a tax burden that would diminish estate funds. The effect of the ruling was to cause the sole shareholder of the debtor’s parent company to be responsible for any federal or state income taxes payable by the debtor. As we wrote then, the case had been appealed to the district court and the appeals were still pending. Since then, the district court certified the appeals to the U.S. Court of Appeals for the Third Circuit, which, on May 21, vacated the bankruptcy court’s order and remanded the case with directions to dismiss the complaint. In so doing, the Third Circuit took direct aim at the bankruptcy court’s expansive view of what constitutes property of the estate in The Majestic Star Casino LLC v. Barden Development (In re The Majestic Star Casino LLC), Nos. 12-3200/3201 (3d Cir. May 21, 2013).

The facts of the case were discussed in our earlier article. The debtor, Majestic Star Casino II (MSC II), was a wholly owned subsidiary of Barden Development Inc. (BDI), which along with its sole shareholder, Don Barden, elected to treat BDI as an S corporation. BDI, in turn, elected to treat MSC II as a QSub. The S corp election resulted in BDI becoming a “pass-through” entity for tax purposes, with all items of income, loss, deduction and credit flowing through the corporation to be reported on the personal tax returns of the corporation’s sole shareholder. A QSub is also a “pass-through” entity, and all of its income and losses flow up to the parent S corp (and then out to the S corp’s shareholders). MSC II filed for bankruptcy and, after the petition date, BDI filed with the Internal Revenue Service to revoke its Subchapter S election, which automatically terminated MSC II’s QSub status. Neither BDI nor Barden sought authorization from the bankruptcy court to change BDI’s tax status. The debtor brought an adversary action against BDI and Barden challenging their action as an unlawful post-petition transfer of the estate’s property. The complaint sought recovery of that “property” through an order directing the IRS to restore retroactively BDI’s status as an S corp and MSC II’s status as a QSub. The bankruptcy court agreed with the debtor and ordered the defendants, including the IRS, to restore the status of MSC II as a QSub of BDI.