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The Eleventh Circuit recently weighed in on a long-standing controversy as to whether Subchapter S status of a corporation is not property of the estate for federal bankruptcy purposes. In reversing the decision of the Bankruptcy Court below, the Eleventh Circuit held that the Subchapter S status is not an interest in property of the debtor-corporation. This issue is plagued with uncertainty as to the correct application of the federal bankruptcy laws and further exacerbated by the numbers of federal bankruptcy courts and judges scattered throughout the country who may take varying views on the subject. The resulting impact of this uncertainty is most adverse on affected S shareholders of financially distressed S corporations forced to report their share of the bankrupt corporation's taxable cancellation of indebtedness income and gain from asset sales in bankruptcy on their individual returns.

In Owoc v. Liquidating Trustee, 2026 WL 2294589, the Eleventh Circuit reversed a federal bankruptcy court’s holding that the automatic stay rule prevented the corporation’s sole shareholder to avoid federal income tax on a substantial gain from the plan or reorganization sale without receiving any cash from the sale from which to pay the tax. This case is an important development in this area off the tax law and intersection with federal bankruptcy law. While the “right” result was denied t0 Mr. Owoc by the federal bankruptcy court and has only now been corrected by the Eleventh Circuit Court of Appeals, it is uncertain whether the Internal Revenue Service or a federal district court having jurisdiction over the remand, can fashion the proper equitable remedy. Indeed, the Appellees had argued that it was "too late" to reverse what had been previously decided by the bankruptcy court. The Eleventh Circuit opinion appeared irritated by that line of legal argument. It stated that the bankruptcy court should now, on remand, fashion a remedy for Mr. Owoc arising out its legally erroneous opinion.

As mentioned, the courts have taken opposite positions on this issue. However, the Third Circuit Court of Appeals and now the Eleventh Circuit Court of Appeals in Owoc v. Liquidating Trustee embrace the same view that S corporation status is not an interest in property of a debtor corporation for bankruptcy law purposes. Choice of forum for filing for bankruptcy is now in play as there are other courts that may continue to take the opposite approach. Perhaps the bankruptcy courts, recognizing that two Circuit Courts of Appeal question their prior thinking and analysis, will re-evaluate their positions particularly in failing to properly take into account Congress' purpose is enacting Subchapter S. Such purpose was to allow owners of small business corporations to elect to be taxed as a flow through entity in a manner similar to partners in partnerships. The S election is a right conferred by Congress to the shareholders and not be denied by the corporation which otherwise would be subject to taxation as a C corporation. It is reasonable to assume that the S corporation problem allows many otherwise failed asset sales to be effectuated under a Chapter 11 reorganization.

The Eleventh Circuit has it "right" on the law and agrees with the Third Circuit and this development is welcome and quite important. Since the United States ironically appeared as an Amicus Curiae on behalf of the Liquidating Trustee and Liquidating Trust which has not always been its position in this area, perhaps the Secretary of the Treasury Department and Ass't Secretary of Tax Policy, can cause legislation to be introduced to achieve results consistent with the Third Circuit's and now the Eleventh Circuit's analysis and holdings in this area. The following post merely summarizes the case law and issues in this area. It can be a "bog" but the bottom line to stepping into the bog on the awkward intersection between Subchapter S and the Bankruptcy Code has clear and dramatic impact to the parties involved who almost always adversaries in these disputes.

Background: Subchapter S

Congress enacted Subchapter S to the Internal Revenue Code to allow owners of small business corporations to obtain partner level treatment afforded partnerships under the pass through rules under Subchapter K. In contrast C corporations subject their shareholders to two levels of taxation, to the corporation under Section 11 (or Section 55) based on a present maximum rate of 21% and then to the shareholders upon distribution of a dividend to the extent of current and/or accumulated earnings and profits. The tax rate on dividends is 37% plus 3.8% tax on net passive investment income subject to exception. Certain dividends may qualify under Section 1(h) for capital gains rate of 20% (plus NII tax).

Subchapter S, subject to C corporations which convert to S status but only for a three-year period, are not subject to corporate income tax. Instead, each shareholder's pro rata share of the corporation's income, deductions, loss and credits pass through to the shareholders on a daily allocation rule for reporting each shareholder's individual return. Stock basis is increased for the pass through of income and additional capital contributions are decreased for losses, deductions, non-deductible expenses not chargeable to capital and distributions. Double taxation is avoided, however distributions to shareholders in excess of the aggregate tax basis in stock are treated as gains from the sale of stock. Tax items including income, losses, deductions, or credits pass through to the shareholder. Income from a C Corporation is taxed both at the corporate level and again at the individual level when dividends are distributed.

The election under Subchapter S requires that the corporation at all times meet the requirements of an electing small business corporation and the corporation files the election (IRS Form 2553) which must be consented to by all shareholders owning stock of the corporation. Once effective, the election to be an S Corporation remains in effect until terminated. The election will be revoked if: (1) shareholders owning more than 50% of the corporation's stock consent to a revocation which is filed by the officers of the corporation; (2) the company no longer qualifies as a “small business corporation”; or (3) “passive investment income exceeds 25% of gross receipts for three consecutive taxable years and [the] corporation has accumulated earnings and profits.” Once terminated, a small business corporation may not make an election to become an S Corporation again for five years, unless permitted by the Secretary of the Internal Revenue Service. For example, the transfer of even one share of stock to an ineligible shareholder or trust, causes an immediate termination of the S election and further results in a S termination year of a S short period and C short period.

In 1996, Congress permitted for the first time for an S corporation to treat a wholly owned subsidiary as a pass through entity through the filing of a qualified Subchapter S subsidiary election (QSUB). Although a separate corporation for state law purposes, a QSUB is not treated as a separate entity income tax purposes and its tax items pass through to the S corporation parent which in turn issues a K-1 to its shareholders in reporting its income and the QSUB or QSUBs income or loss. A parent S corporation may revoke the QSUB election by filing a statement with IRS.

Subchapter S Entities in Bankruptcy

The financially distressed S corporation raises serious tax issues and impacts to shareholders of the trouble S corporation. In seeking bankruptcy protection, the shareholders of the corporation are adverse to the interests of the corporation since the corporation may realize substantial levels of cancellation of indebtedness income as well as gain in the event of a Chapter 11 plan of reorganization and asset sale. If the debtor corporation is not a C corporation, then the tax liabilities generated from the COD income or gain from asset sales, etc., will be passed through to the shareholders who generally will not be receiving cash in order to meet their obligations for the pass-through income amounts. A true phantom income spectacle. This could occur with respect to a financially trouble QSUB seeking bankruptcy protection as well.

The filing of a petition in bankruptcy under Chapter 11 of the Bankruptcy Code immediately creates a bankruptcy estate under §541. This estate contains “all legal and equitable interests of the debtor in property” with some exceptions. The Bankruptcy Code does not define “property” or “interests in property” but generally relies on the state law, unless federal law is controlling. The Supreme Court has recognized that the scope of “property” is construed more generously for bankruptcy purposes than other contexts in order to “secure for creditors everything of value the bankrupt may possess.” See Segal v. Rochelle, 382 US 375 (1966). Even contingent and future interests are included within the meaning of property of the estate even if non-transferable by the debtor.

Until the Third Circuit's decision in Majestic Star Casino, 718 F.3d 736 (3rd Cir. 2013), the courts have held that a trustee in bankruptcy can avoid the shareholders' attempted revocation of S corporation status regardless of whether the attempted revocation was pre-petition or post-petition. The reason? Because the S election and status of the debtor corporation under Subchapter S constituted "property of the estate". Thus, the chapter 11 asset sale and COD income passed through to the shareholders and not incurred by the debtor-corporation. From an economic standpoint, the push-down of the tax on gain and COD income to the debtor shareholders had a very high value to the creditors committee and the proposed buyer who further benefits from a asset cost basis in the acquired property and assumption of debt. This occurred in Bakersfield Westar, Inc., 226 B.R. 227 (B.A.P. 9th Cir. 1998), where the shareholders revoked the corporation's S election two weeks prior to filing for Chapter 7 in straight bankruptcy. The revocation would have shifted capital gains from the liquidation off the company from the shareholders to the debtor company. The trustee rejected the revocation alleging it was a fraudulent conveyance that should be an avoidable transfer maintaining that the S status of the debtor corporation was a "valuable property right". Ironically, the IRS argued that the tax status was not a property interest since it had no present value. The Bankruptcy Appellate Panel of the Ninth Circuit agreed with the trustee and held that the revocation of the election was to be ignored. Similarly, a revocation of S status post-petition was declared void for violating the stay rule and voidable post-petition transfer in In re Waterman Implement, Inc., 2006 WL 1562401 (N.D. Iowa 2006).

Both Bakersfield Westar, Inc., supra, and In re Waterman Implement, Inc., supra, rely on the reasoning of a Tennessee bankruptcy court in In re Trans-Lines, West, Inc. that first decided that a debtor corporation's S status was property of the estate. In that case the debtor's sole shareholder elected to revoke S status one month before filing for bankruptcy under Chapter 11. The trustee initiated an adversary proceeding claiming the revocation was voidable as a fraudulent transfer under 11 U.S.C. 548. The Court postulated that tax status is property because, under federal law, an S corporation "has the right to use, enjoy and dispose of that status". The Court analogized the S election to net operating losses. Once an election is made for example to carry back or carry forward an NOL under Section 172 such election is treated as irrevocable. A similar analysis was set forth in In re Russell, 927 F.2d 413 (8th Cir. 1991).

Third Circuit Court of Appeals Issues Majestic Star Opinion

In Majestic Star Casino, LLC v. Barden Development, Inc., 716 3d 736 (3rd Cir. 2013), the Third Circuit Court of Appeals reversed the decision of the Bankruptcy Court and held that the revocation of a non-debtor parent corporation's S status, which automatically caused its debtor subsidiary to lose its QSUB election status, was not an unlawful transfer of the debtor subsidiary's bankruptcy estate “property." This planning shifted the incidence of federal income taxation from the sole shareholder of the S corporation parent company to the individual former QSUB subsidiaries. The Third Circuit vacated and remanded the bankruptcy court's decision that revocation of the parent corporation's S status which effectively terminated the QSUB status of its subsidiaries was an unlawful transfer of the subsidiary's bankrupt estate's property on the basis that the parent corporation's S status and afortioari QSUB status of the subsidiary were items for which the subsidiary had no control and did not constitute "property" of the estate, or in any event would be property of the parent rather than of the bankrupt subsidiary.

Several years later the United States Bankruptcy Court for the Eastern District of Virginia in In Re: Health Diagnostic Laboratory, Inc. et al v. United States, 578 B.R. 552 (2017) held that a debtor S corporation status was not property o the bankruptcy estate. In a well reasoned analysis, the Bankruptcy Court stated that "[W]hile federal law creates the bankruptcy estate, [the US Supreme Court in] Butner, 440 U.S. 48 (1979) and the cases following it establish that state law, absent a countervailing federal interest, determines whether a given property falls within this federal framework". Therefore, the revocation of Subchapter S status is not an "essential property rights" factors identified by the Fourth Circuit Court of Appeals and therefore the Court held that Subchapter S status is not a interest in property of the estate under the Bankruptcy Code. While the status may be valuable to the estate it does not constitute an asset of the debtor.

John H. Owoc v. Liquidating Trustee on Behalf of Liquidating Trust: Federal Bankruptcy Court

John Owoc founded VPX in 1993 and served as a director and officer until 2023. In 1997, Mr. Owoc, as VPX's sole shareholder, elected to classify VPX as a Subchapter S Corporation pursuant to 26 U.S.C. § 1362(a). On October 10, 2022, VPX—along with co-debtors Bang Energy Canada, Inc., JHO Intellectual Property Holdings, LLC, JHO Real Estate Investment, LLC, Quash Seltzer, LLC, Rainbow Unicorn Bev LLC, and Vital Pharmaceuticals International Sales, Inc.—filed a voluntary Chapter 11 bankruptcy petition. Five months later, on March 9, 2023, a reconstituted board of VPX removed Mr. Owoc from his position as Chief Executive Officer and terminated his membership on the board. But Mr. Owoc remained VPX's sole shareholder. In July of 2023, Mr. Owoc filed an emergency motion for confirmation that the automatic bankruptcy stay, see 11 U.S.C. § 362, did not apply to revocation of VPX's Subchapter S status, or, alternatively, for relief from the stay. The bankruptcy court denied the motion. It reasoned that “[b]ecause [VPX's] S election gives it the valued right to avoid tax liability, the S election is property of the estate and therefore protected by the automatic stay.” In re Vital Pharms., 655 B.R. 374, 392 (Bankr. S.D. Fla. 2023). That same month, VPX sold its assets to Blast Asset Acquisition, LLC, a subsidiary of Monster Energy Company. Then, pursuant to the reorganization plan, VPX's remaining interests were automatically and irrevocably vested in a trust. Thereafter, Mr. Owoc filed an expedited motion for relief from the automatic stay so that he could terminate VPX's Subchapter S election. The bankruptcy court denied that motion. Mr. Owoc appealed the first bankruptcy court decision to the district court, and the trustee moved to dismiss the appeal as moot. The district court denied the motion to dismiss. It then consolidated Mr. Owoc's appeals of the first and second bankruptcy decisions and granted his request for certification of a direct appeal to the Eleventh Circuit Court of Appeals.

Eleventh Circuit Court of Appeals Rules in Favor of Owoc: S Corporation Status Is Not Property of the Estate in Federal Bankruptcy

The Eleventh Circuit in its unanimous 3-0 decision, rejected the Bankruptcy Court's reasoning and analysis as well as the reasoning of the other courts that held that S corporation status is "property", and noted that there are two fundamental errors of law that were made below. First, the treatment of net operating loss carryovers as having the same status and characterization as S corporation status of a debtor corporation is flawed. NOLs are based on prior operational history of the corporation at the time of bankruptcy filing and are not subject to revocation by the taxpayer or by the IRS. This was pointed out by the Third Circuit as well in Majestic Star, supra. Second, the enjoyment of a benefit which may have value to the bankrupt estate is not, per se, property of the Estate. That describes the Subchapter S status. Indeed, as the Third Circuit acknowledged and as further articulated in In re: Health Diagnostic Laboratory, Inc., supra, a "corporation cannot claim a legal or equitable property interest to a valuable benefit that another party has the power to legally revoke at any time". Congress conferred the right to the shareholders to elect or terminate Subchapter S.

It is acknowledged that the taxpayer here may not have an adequate remedy at law due to the time that has elapsed in the interim and for the further fact that the Chapter 11 plan was approved and the sale effectuated. The government believes Mr. Owoc is responsible for all taxes owed on COD and gain on gain on sale. The buyer got a step up in tax basis. Something is wrong. The buyer crams down the sale price and the shareholders of the S corporation debtor are stuck with income tax that would otherwise be taxable to the debtor corporation seller. The bankruptcy code fosters a "reverse preference" to the Chapter 11 buyer and creditors. Congress needs to revisit this issue.

The government should fashion an equitable remedy or the aggrieved taxpayer. The Eleventh Circuit identified this problem.

THIS POST IS INTENDED FOR EDUCATIONAL AND INFORMATIONAL PURPOSES ONLY AND MAY NOT BE RELIED UPON BY THE READER OR OTHERWISE TREATED AS LEGAL ADVICE. PLEASE CONSULT WITH YOU TAX ADVISOR OR TAX COUNSEL ON QUESTIONS IN THIS AREA. OF COURSE AUGUST TAX LAW, P.C. WELCOMES YOUR CONTACTING US.