Corporate Tax Status Isn’t Property of Chapter 11 Debtor

By Diane Davis

A debtor’s S corporation status isn’t “property” under federal tax law and for fraudulent transfer purposes in bankruptcy, the U.S. Bankruptcy Court for the Eastern District of Virginia held.

This conclusion is “consistent with the complementary provisions of the Bankruptcy Code and Tax Code,” Judge Kevin R. Huennekens wrote Dec. 6, on an issue first being considered by a court in the Fourth Circuit.

While only a handful of courts have considered the issue in the context of fraudulent transfers, the Third Circuit is the only court to conclude that S corporation status isn’t a property right in bankruptcy, the court said.

“The Liquidating Trustee cannot use the fraudulent transfer provisions of the Bankruptcy Code to maneuver around the strict requirements of the Tax Code,” the court said.

Health Diagnostic Laboratory, Inc. (HDL) provides clinical laboratory services to physicians and reimburses referring physicians for the costs associated with collecting, processing, and handling blood samples.

After a fraud alert, negative publicity, and lawsuits alleging violations of federal anti-kickback laws, HDL filed Chapter 11. The court approved the sale of substantially all of HDL’s assets to True Health Diagnostics, LLC.

As a small business corporation, HDL’s board of directors elected to be classified as an S corporation to prevent the double taxation of a C corporation. S corporations pass through corporate income, losses, deductions, and credits to their shareholders, the court said.

After the Chapter 11 filing, however, the shareholders revoked that status making it subject to C corporation tax.

The liquidating trustee wanted the court to avoid the revocation of S corporation status as a fraudulent transfer.

“The fact that something confers value to the estate does not necessarily create a property right in it,” the court said.

The benefit is to the shareholders because it allows them to avoid double taxation as in a C corporation, the court said. The shareholders elect S status, not the corporate entity, and any interest in electing S corporation status belongs to the shareholders, the court said.

Hunton & Williams, Richmond, Hirschler Fleischer, P.C., RIchmond, represented Health Diagnostic Laboratory, Inc.; Cooley LLP, Reston, Va.; Cullen Drescher Speckhart, Wolcott Rivers Gates, Richmond, represented liquidating trustee Richard Arrowsmith; Shannon Pecoraro, Robert B. Van Arsdale, Office of the U.S. Trustee, Richmond, represented U.S. Trustee Judy A. Robbins; and Kieran O. Carter and Ari David Kunofsky, Dept. of Justice, Washington, D.C., represented the U.S.

The case is Arrowsmith v. United States (In re Health Diagnostic Lab., Inc.) , 2017 BL 436240, Bankr. E.D. Va., No. 17-04300, 12/6/17 .

To contact the reporter on this story: Diane Davis in Washington at ddavis@bloomberglaw.com

To contact the editor responsible for this story: Jay Horowitz at jhorowitz@bloomberglaw.com

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