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A Majestic Departure: The Third Circuit Narrows Interpretation Of “Property Of The Estate” Based On Debtor’s Lack Of Control

Financial Restructuring and Bankruptcy Alert | August 21, 2013
By: Amy E. Vulpio

In its recent decision in Majestic Star Casino, LLC v. Barden Development, Inc. (In re Majestic Star Casino, LLC), 2013 WL 2162781 (3d Cir. May 21, 2013), the United States Court of Appeals for the Third Circuit boldly bucked the modern trend toward broadly defining the scope of estate property by finding that a debtor’s tax status was not property of the debtor’s bankruptcy estate. In bankruptcy, understanding what constitutes property of the estate is crucial for the debtor, its creditors, and all other parties in its orbit.  A debtor can sell property of the estate to generate desperately needed liquidity.  An asset purchaser can buy estate property free and clear of liens, claims, encumbrances and other interests, often at a substantial discount due to the debtor’s financial distress.  For creditors and contract counterparties, any attempt to exercise control over property of a debtor’s estate may be void or voidable as a violation of the automatic stay, and willful stay violations may even subject the violator to sanctions.  Accordingly, disputes concerning the scope of estate property can – and routinely do – arise at various stages of a bankruptcy case. 

The Bankruptcy Code defines “property of the estate” as “all legal or equitable interests of the debtor in property as of the commencement of the case.”  See 11 U.S.C. § 541(a)(1).  Over the years, courts have construed estate property increasingly broadly.  In Majestic Star, however, the Third Circuit recognized – but dramatically departed from – this modern trend.  The Third Circuit’s ruling seems destined to breathe new life into the debate as to what does – and, equally importantly, what does not – constitute property of a debtor’s estate.

Igniting New Debate: Majestic Star

Debtor Majestic Star Casino II, Inc. (Debtor) was a wholly-owned, qualified subchapter S subsidiary (Q-sub) of non-debtor S corporation (S-corp), Barden Development, Inc. (Parent).  After Debtor’s bankruptcy filing and without bankruptcy court approval, Parent’s sole shareholder successfully petitioned the IRS to revoke Parent’s S-corp status, which under the Internal Revenue Code caused the automatic termination of Debtor’s Q-sub status.  The change detrimentally affected Debtor by subjecting it to state and federal taxation, from which it had previously been exempt because the income of S-corps and Q-subs “passes-through” to shareholders for tax purposes.  Debtor filed an adversary complaint seeking a determination that the revocation of Parent’s S-corp status constituted an unlawful post-petition transfer of property of Debtor’s bankruptcy estate in violation of 11 U.S.C. § 362’s automatic stay and/or 11 U.S.C. § 549, which prohibits the post-petition transfer of property of the estate without bankruptcy court authorization.  Parent and the IRS opposed Debtor’s request, arguing that a Q-sub’s tax status was not estate property and that, even if it were, it would be Parent’s property (not Debtor’s), such that Debtor lacked standing to challenge the revocation.

The bankruptcy court considered whether an entity’s Q-sub tax status was “property” and, if so, whether it was property of the debtor subsidiary or its non-debtor corporate parent.  Following the modern trend, the bankruptcy court construed estate property broadly and held that Debtor’s Q-sub status was indeed property of its bankruptcy estate because it had value to Debtor.  As the revocation occurred without bankruptcy court authorization, the bankruptcy court ordered Parent and the IRS to take all actions necessary to restore Debtor’s Q-sub status.  A direct appeal from the bankruptcy court to the Third Circuit was authorized.

In reversing the bankruptcy court, the Third Circuit acknowledged that other courts had construed “estate property” increasingly broadly to include even the mere opportunity to receive a future economic benefit.  For example, in In re Prudential Lines Inc., 928 F.2d 565 (2d Cir. 1989), the Second Circuit reasoned that “property of the estate” included even contingent and future interests, and held that – because of their potential value to the estate – an entity’s net operating losses were estate property.  The Third Circuit itself cited Prudential Lines with favor in In re Fruehauf Trailer Corp., 444 F.3d 203 (3d Cir. 2006).  While recognizing that other courts had universally found debtors’ S-corp status to be estate property, the Third Circuit concluded in Majestic Star that such courts were universally wrong.  The Bankruptcy Code’s definition of estate property says nothing about contingent or future interests, see 11 U.S.C. § 541(a)(1), and the Internal Revenue Code does not guarantee a corporation’s S-corp status.  Rather, S-corp status may be revoked with the approval of more than half of the entity’s shareholders, and automatically terminates if the corporation no longer qualifies as a “small business corporation,” which may occur, for example, if an individual shareholder sells his or her shares to a corporation or if the number of shareholders exceeds one-hundred (100).  A Q-sub enjoys even less control over its tax status, which may be affected either by the parent or the parent’s shareholders.

In part, equitable considerations informed the Majestic Star decision.  Treating Debtor’s Q-sub status as property of Debtor’s estate would have expanded Debtor’s rights at the expense of Parent, deprived Parent of the opportunity to change its own S-corp election, and restricted Parent’s ability to sell its shares (at least without first obtaining relief from the automatic stay).  Yet, rather than simply ruling that, to the extent a Q-sub’s tax status was “property,” it belonged to the parent rather than the subsidiary, the Third Circuit made the broader determination that an S-corp’s tax status was not estate property either.  Forgoing the opportunity to blunt the impact of its ruling, the Third Circuit’s ruling in Majestic Star created a potentially slippery slope based on its perception that neither Parent nor Debtor controlled Debtor’s tax status.  Because Parent’s shareholders ultimately controlled Debtor’s tax status, the status had no realizable value that could be marshaled for distribution to Debtor’s creditors and was not estate property. 

How Much Control Is Required?

In departing from the trend to broadly define estate property, the Third Circuitopened a potential Pandora’s box with its Majestic Star decision.  While the Internal Revenue Code does not guarantee an entity’s tax status, a corporation itself may preserve and protect the value of its tax status through creative legal strategies.  While acknowledging in a footnote that an entity may contractually mitigate this risk (for example, by an agreement among shareholders limiting the alienability of shares), the Majestic Star court completely discounted this possibility.  Even in the absence of such precautions, the mere fact that a shareholder might destroy an S-corp’s pass-through status by transferring his or her stock could logically affect the value of the entity’s interest without necessarily compelling the conclusion that the tax status is not an interest in property.  Moreover, the equitable considerations that influenced the ruling were arguably overblown.  Treating Debtor’s Q-sub status as property of its estate would not have completely foreclosed Parent or its shareholders from a post-petition revocation, but would have required them to obtain relief from the automatic stay before doing so.  Bankruptcy court authorization is required for any number of comparable actions that, outside bankruptcy, could proceed unfettered.

Accordingly, Majestic Star raised more questions than it answers.  What if a debtor had a contract that its customer could terminate at any time without penalty?  Would the debtor’s lack of control mean that the contract was not property of the debtor’s estate, or would it simply affect the value of the contract?  What about a cause of action?  Would the fact that a debtor may have only limited control over the outcome of litigation compel the conclusion that the claim was not property of the estate?  As these examples illustrate, Majestic Star’simplications extend far beyond the tax status context and the ruling will inevitably be invoked to advocate for a narrow interpretation of estate property for any number of objectives.  By linking the concept of control to “property of the estate,” Majestic Star gave bankruptcy litigants and their counsel credible, good faith arguments on both sides of a previously well-settled legal issue. 

This correspondence should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult a lawyer concerning your own situation and legal questions.
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