Many large-scale equity investments will be structured to use so-called "flow-through" structures, such as partnerships or limited liability companies that do not "check the box," as part of general tax planning. Indeed, private equity sponsors, in particular, will commonly structure investments where the operating businesses, and obligors on substantial amounts of debt, are not taxpayers. Instead, tax obligations, such as income tax, will flow through to the equityholders of the ultimate parent, with the applicable tax bills then being funded by tax distributions as required by the operative organizational documents.
Debt restructurings involving a flow-through structure can, and often do, turn this tax relationship on its head. A restructuring, such as a bankruptcy, a consensual debt reduction, or even a maturity extension and interest rate modification can trigger cancellation of indebtedness income (commonly referred to as "CODI") that is both taxed as ordinary income and flows directly to equityholders.1 Equityholders can then face a double whammy of both the loss of their original investment and a large tax bill for which no offsetting tax distributions are available. As a result, the importance of careful tax planning in a potential liability management or restructuring transaction is even greater where flow-through structures are involved.
determined that a bankrupt corporation's status as an S corporation, which causes the entity to be treated as a "flow-through" entity for tax purposes, is an asset of the bankruptcy estate;- held that a shareholder cannot unilaterally alter the bankrupt entity's flow-through status without also violating the automatic stay; and
- rejected the Third Circuit Court of Appeals' 2013 decision, In re The Majestic Star Casino, LLC, 716 F.3d 736 (3d Cir. 2013), which had determined that a bankrupt corporation's flow-through status was not an asset protected by the automatic stay.
If more widely followed, Vital Pharmaceuticals may have much broader implications for borrowers and obligors structured as flow-through entities, such as partnerships, REITs, and limited liability companies that do not "check the box."
Background
Historically, courts have taken different approaches regarding the treatment of S corporation elections in the context of a bankruptcy, but in the decade since Majestic Star, and until Vital Pharmaceuticals, no court had treated S corporation status as property of the debtor's bankruptcy estate in such unequivocal fashion.
If shareholders of an S corporation are permitted to revoke the S election, the entity in question will cease to be treated as a flow-through entity for U.S. federal income tax purposes, and will instead, be taxed as a C corporation. Thus, income of the corporation will be taxed at the corporate level, rather than flowing up to the shareholder(s), potentially increasing the tax liabilities of the debtor where the corporation is in bankruptcy. Conversely, the shareholders of an S corporation will remain liable for taxable income generated by the S corporation where the S election remains in place. And, since material income tax liabilities can be generated in bankruptcy or in distressed circumstances more generally (such as from a taxable sale of the debtor's assets), shareholders and creditors may have very different views on how the tax status of a debtor-entity should be addressed.
Prior to Majestic Star, the prevailing understanding was that S corporation elections, like NOLs, were property of an S corporation's bankruptcy estate. This principle was first clearly established by In re Trans-Line West, Inc., 203 B.R. 653 (Bankr. E.D. Tenn. 1996), which then provided the basis for a number of other related decisions. Majestic Star, however, rejected this conclusion and determined that S corporation status is not "property" within the meaning of the Bankruptcy Code. The Majestic Star court's departure from Trans-Lines West was, in part, due to the fact that S corporation status is determined by the company's shareholders and, at least in the Majestic Star court's view, the right to maintain (or revoke) that election would always be subject to change. Majestic Star, 716 F. 3d at 756.
The Vital Pharmaceuticals Ruling
In Vital Pharmaceuticals, the sole shareholder of an S corporation, John Owoc, attempted to revoke the debtor's S corporation election for a company in the midst of bankruptcy. Vital's assets were auctioned off for $370 million. Per the Vital Pharmaceuticals opinion, there was not expected to be any remaining cash after the company pays its debts, and because of the company's S corporation status, all taxable income resulting from the sale would flow up to Owoc, and he, rather than Vital, would be liable for the resulting taxes. This flow-through would provide significant benefits to the debtor, and its creditors, by eliminating an otherwise potentially large tax burden arising from the sale of assets and would, in turn, permit Vital to pay its administrative expenses and provide recoveries to unsecured creditors. By contrast, according to the Vital Pharmaceuticals court, if Owoc were allowed to terminate Vital's S corporation status, the bankruptcy estate would have incurred $27.5 million in tax liability, which would have caused the Vital bankruptcy estate to be administratively insolvent, and unsecured creditors would have received nothing.
In its analysis, the Vital Pharmaceuticals court criticized the logic employed in Majestic Star, pointing out that a debtor's ability to reduce its tax liability is a valuable asset. Vital Pharm., 2023 Bankr. LEXIS at *23-24. Further, the Vital Pharmaceuticals court stated that the mere fact that a property right is contingent or non-transferable, such as an S corporation election, does not prevent that right from being property of the bankruptcy estate. In this respect, the Vital Pharmaceuticals approach is largely consistent with the Bankruptcy Code's more general proposition that "property of the estate" as defined by section 541 is to be given an expansive meaning. See 11 U.S.C. § 541(a); see, e.g., In re Residential Capital, LLC, 556 B.R. 555, 560 ("This definition of property has been given the broadest possible interpretation." (internal quotation marks omitted)). Regardless, the Vital Pharmaceuticals court concluded that an S election is property of the company's bankruptcy estate and, therefore, subject to an automatic stay, which bars Owoc from revoking the election.2
Takeaways from Vital Pharmaceuticals
What may have been settled law under Majestic Star may now be up for debate. As Florida is part of the Eleventh Circuit, the Majestic Star ruling, which arose in the Third Circuit and remains the only Court of Appeals decision to consider this issue, was not binding precedent for the Vital Pharmaceuticals court. The inconsistent rulings in this area may cause other courts outside the Third Circuit to revisit the issue as well.
The decision in Vital Pharmaceuticals could also have reverberations beyond the S corporation context, as the same logic could be applied to other flow-through entities, such as partnerships, disregarded entities and REITs. If so expanded to other flow-through entities, the reasoning in this decision could be applied differently depending on whether the debtor is a parent of a flow-through entity or is itself a flow-through entity. If flow-through status generally becomes considered property of a flow-through debtor's estate, even pre-bankruptcy changes to a debtor's flow-through tax classification could potentially be unwound by a bankruptcy court under certain circumstances.
As shown by the facts of Vital Pharmaceuticals, flow-through tax status (or lack thereof) can determine whether millions of dollars of taxes are owed by a debtor or a non-debtor. As any such income tax liabilities are often administrative or priority claims, flow-through tax status should not be overlooked by debtors and their stakeholders.
We will continue to monitor the changing landscape for flow-through debtors. We encourage you to contact your Ropes & Gray team to discuss these matters more fully.3
Footnotes
1. Under certain circumstances, amending existing debt instruments, such as maturity extensions, interest rate modifications, a change in covenants, payment deferrals, and/or the inclusion (or exclusion) of collateral and obligors can constitute a "significant modification" under the applicable U.S. tax regulations that, in turn may result in CODI. What constitutes a "significant modification" in this regard is a highly fact-intensive exercise and is beyond the scope of this Client Alert. We encourage you to consult with your Ropes & Gray team to assess any particular circumstances where "significant modification" considerations may be relevant.
2. Owoc filed an appeal of the bankruptcy court's ruling on October 19, 2023.
3. Ropes & Gray LLP represents certain members of the board of directors of Vital Pharmaceuticals, Inc. in connection with various matters related to that company's restructuring.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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