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Emory Bankruptcy Developments Journal

Abstract

This Comment focuses on whether the tax status of a debtor constitutes “property” of the debtor’s estate under 11 U.S.C. § 541(a). The answer to this question ultimately determines whether a bankruptcy trustee has the power to avoid a “check-the-box” tax status change made by the owner of a debtor entity from a “pass-through” to a separately taxed C Corporation. This issue normally arises when the parent corporation or individual owner of a debtor subsidiary corporation or disregarded entity (to the individual owner) elects to transform the status of the debtor by “checking the box” on the proper federal tax form.

This Comment utilizes a hypothetical scenario involving an individual who owns a pass-through entity which holds a completely depreciated piece of real property. The individual decides to leverage the piece of real property but, through a series of misfortunes, is subsequently forced to place the entity holding that real property into bankruptcy. In bankruptcy, the distressed property is sold in a forced sale that is a taxable event. The individual owner of the debtor entity is motivated to make a prepetition or post-petition tax status change in entity type to a C Corp because the tax obligation resulting from the gain on sale of the real estate no longer “passes through” to the owner’s tax return once the change is made. Instead, the tax gain remains with the newly-transformed C Corp and the bankruptcy estate. In effect, the change in tax status allows the owner of a debtor entity to shift the tax burden normally flowing to the owner as a pass-through gain to instead be paid by the bankruptcy estate simply by making a change on a tax form. Check-the-box changes can also tangibly affect other kinds of tax attributes, such as the ability to use NOLs.

Courts are split on whether the debtor entity’s tax status constitutes property. This Comment advocates for the position taken by the Third Circuit, that ultimate control of the debtor’s tax status is contingent on the will of the parent-owner of the debtor and is therefore, not property. This Comment argues against courts within the Sixth and Ninth Circuits, which have held that tax attributes of a debtor are property of the debtor’s estate protected by the automatic stay under 11 U.S.C. § 362(a) and are therefore subject to the trustee’s avoidance powers under sections 544, 548, and 549 of the Bankruptcy Code.

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