Argued February 19, 2013.
On Appeal from the United States Bankruptcy Court for the District of Delaware (B.C. No. 10-56238) Bankruptcy Judge: Hon. Kevin Gross.
Kathryn Keneally Thomas J. Clark Ivan C. Dale [ARGUED] Tax Division Department of Justice, Melissa L. Dickey United States Department of Justice Tax Division, Charles M. Oberly United States Attorney, Counsel for Appellants The United States of America.
Steven D. Carpenter, Counsel for Appellant Indiana Department of Revenue.
Mary F. Caloway Buchanan Ingersoll & Rooney Gerald M. Gordon [ARGUED] Erika Pike Turner Gordon Silver Anthony Ilardi, Jr. Katherine Murphy William Lentine Dykema Gossett, PLLC, Counsel for Barden Appellants.
Lauren O. Casazza [ARGUED] Warren Haskel Kirkland & Ellis Kathleen P. Makowski James E. O'Neill, III Pachulski Stang Ziehl & Jones Counsel for Appellees.
Before: AMBRO, JORDAN, and VANASKIE, Circuit Judges.
JORDAN, Circuit Judge.
This case arises from a corporate reorganization under Chapter 11 of the Bankruptcy Code, 11 U.S.C. § 101 et seq. (the "Code"), and puts at issue whether a non-debtor company's decision to abandon its classification as an "S" corporation for federal tax purposes, thus forfeiting the pass-through tax benefits that it and its debtor subsidiary had enjoyed, is void as a postpetition transfer of "property of the bankruptcy estate, " or is avoidable, under §§ 362, 549, and 550 of the Code. This appears to be a question of first impression in the federal Courts of Appeals.
Barden Development, Inc. ("BDI"), John M. Chase, as the personal representative of the estate of Don H. Barden(together with BDI, the "Barden Appellants"), and the Internal Revenue Service (the "IRS") appeal an order of the United States Bankruptcy Court for the District of Delaware granting summary judgment to The Majestic Star Casino, LLC and certain of its subsidiaries and affiliates (collectively "Majestic" or the "Debtors") on their motion to avoid BDI's termination of its status as an "S" corporation (or "S-corp"), an entity type that is not subject to federal taxation. In November 2009, the Debtors, which had been controlled by Barden, filed petitions for relief under Chapter 11 of the Code. After the bankruptcy filing, Barden, as sole shareholder of BDI, successfully petitioned the IRS to revoke BDI's S-corp status. Under the Internal Revenue Code ("I.R.C."), that revocation also caused Majestic Star Casino II, Inc. ("MSC II"), an indirect and wholly-owned BDI subsidiary and one of the Debtors, to lose its status as a qualified subchapter S subsidiary (or "QSub"), which meant that it, like BDI, became subject to federal taxation.
The Debtors were by then effectively controlled by their creditors and, naturally, did not agree with shouldering a new tax burden. They filed an adversary complaint asserting that the revocation of BDI's S-corp status caused an unlawful postpetition transfer of property of the MSC II bankruptcy estate. The Bankruptcy Court agreed and ordered the Barden Appellants and the IRS to reinstate both BDI's status as an S- corp and MSC II's status as a QSub. The case was certified to us for direct appeal. For the reasons that follow, we will vacate the Bankruptcy Court's January 24, 2012 order and remand this matter to the Court with directions to dismiss the complaint.
1. The Parties
Defendant-Appellant BDI is an Indiana corporation with its headquarters in Detroit, Michigan. Defendant-Appellant Barden was, at all pertinent times, the sole shareholder, chief executive officer, and president of BDI. At the time of the complaint, BDI qualified as a "small business corporation" under I.R.C. § 1361(b), and, presumably at Barden's direction, had elected under I.R.C. § 1362(a) to be treated as an S-corp for purposes of federal income taxation. As an S-corp, BDI was not subject to federal taxation, see I.R.C. § 1363(a),  or state taxation. Rather, its income and losses were passed through to its shareholder, Barden, who was required to report BDI's income on his individual tax returns. See I.R.C. §§ 1363(b), 1366(a).
Plaintiff-Appellee MSC II is a Delaware corporation that owns and operates the Majestic Star II Casino and the Majestic Star Hotel in Gary, Indiana. MSC II generates income from those operations. BDI acquired MSC II in 2005 and was, at all times relevant to this dispute, the ultimate owner of 100 percent of its stock. Prior to the Debtors' bankruptcy petition, BDI elected to treat MSC II as a QSub for federal tax purposes, pursuant to I.R.C. § 1361(b)(3)(B). That meant that MSC II was not treated as a separate tax entity from BDI, but rather that all of its assets, liabilities, and income were treated for federal tax purposes as the assets, liabilities, and income of BDI. See id. § 1361(b)(3)(A). As a result, MSC II paid no federal taxes and all of its income and losses flowed through to Barden (through BDI), and he was required to report them on his individual tax returns. See Treas. Reg. § 1.1366-1(a). BDI was able to elect to treat MSC II as a QSub because the latter met the statutory requirement that it was wholly owned by an S-corp, ultimately BDI. See I.R.C. § 1361(b)(3)(B); supra notes 5 and 6.
2. The Majestic Bankruptcy and the Revocation of MSC II's QSub Status
On November 23, 2009 (the "Petition Date"), MSC II and the other Debtors filed voluntary petitions for bankruptcy relief under the Code, and the Bankruptcy Court subsequently ordered that their Chapter 11 cases be jointly administered. The Debtors became debtors-in-possession of their respective bankruptcy estates, and thus had, with limited exceptions not relevant here, all of the powers and duties of a bankruptcy trustee in a Chapter 11 case. At the Petition Date, both BDI and MSC II retained their status as, respectively, an S-corp and a QSub. Barden and BDI did not file bankruptcy petitions, nor did they participate as debtors in any of the petitions at issue in this case.
In addition to certain events that automatically revoke an entity's election to be treated as an S-corp,  that tax status may also be revoked if more than half of the corporation's shareholders consent to the revocation. I.R.C. § 1362(d)(1)(B). If S-corp status is revoked, the entity cannot elect such status again within five years of the revocation without the consent of the Secretary of the Treasury. Id. § 1362(g).
Sometime after the Petition Date, Barden, BDI's sole shareholder, caused and consented to the revocation of BDI's status as an S-corp, and BDI filed a notice with the IRS to that effect. The revocation was retroactively effective to January 1, 2010, the first day of BDI's taxable year. As a result, MSC II's QSub status was automatically terminated as of the end of the prior tax year (the "Revocation"), because it no longer met the requirement that it be wholly owned by an S-corp. Thus, both BDI and MSC II became C-corporations as of January 1, 2010. As a consequence of becoming a C-corporation, MSC II became responsible for filing its own tax returns and paying income taxes on its holdings and operations.
Neither BDI nor Barden sought or obtained authorization from the Debtors or from the Bankruptcy Court for the Revocation. The Debtors did not learn of the Revocation until July 19, 2010, which is believed to be at least four months after Barden and BDI filed the S-corp revocation with the IRS. See supra note 9. The Debtors allege that, because MSC II was not informed of the Revocation, it was unaware that it had a new obligation to report and pay income taxes. They also allege that, due to the change in MSC II's tax status, MSC II had to pay approximately $2.26 million in estimated income tax to the Indiana Department of Revenue for 2010 that it otherwise would not have had to pay. However, as of April 2011 (the first date federal taxes would have been due following the Revocation), the Debtors had paid no federal income taxes as a result of the Revocation.
3. Confirmation of the Majestic Plan and Its Effect on MSC II
On December 10, 2010, prior to the Debtors' filing of the adversary complaint that initiated this action, the Bankruptcy Court issued an order permitting the Debtors to convert MSC II from a Delaware corporation to a Delaware limited liability company ("LLC"). On March 10, 2011, the Court entered an order confirming the Debtors' Second Amended Plan of Reorganization (the "Plan"). Pursuant to the Plan, as of December 1, 2011 (the "Effective Date"), new membership interests representing all of the equity interests in MSC II were to be issued to holders of certain senior secured debt. On November 28, 2011, just prior to the Effective Date, the Debtors went ahead and caused MSC II to convert to an LLC. That conversion meant that MSC II would no longer have qualified for QSub status, even if the Revocation had not already occurred. See I.R.C. § 1361(b)(3)(B) (requiring that a QSub be a "domestic corporation"). Also, as part of the Plan of Reorganization, MSC II ceased to be wholly owned by an S-corp, so that, even absent the LLC conversion, and independent of the Revocation, MSC II would no longer have qualified as a QSub. The Debtors' Plan of Reorganization was substantially consummated on December 1, 2011, and MSC II emerged from bankruptcy together with the other Debtors on that date.
B. Procedural History
On December 31, 2010, the Debtors filed an adversary complaint in the Bankruptcy Court, asserting that the Revocation caused an unlawful postpetition transfer of MSC II's estate property, in violation of §§ 362 and 549 of the Bankruptcy Code. The complaint sought recovery of that "property" under Code § 550, through an order "directing the IRS and [the] Indiana [Department of Revenue] to restore BDI's status as an S corporation and MSC II's status as a QSub retroactively effective January 1, 2010." (App. at 50.).
The IRS moved to dismiss the Debtors' adversary complaint on February 14, 2011, contending that the Bankruptcy Court lacked jurisdiction and that the Debtors failed to state a claim under Federal Rules of Civil Procedure 12(b)(1) and 12(b)(6) (incorporated by Federal Rule of Bankruptcy Procedure 7012(b)). More particularly, the IRS argued that the Bankruptcy Court lacked jurisdiction under Code § 505(a)(1) because the Debtors had not alleged that MSC II had actually paid any federal corporate income taxes or filed any federal income tax returns prior to initiating their adversary proceeding, so that their claims were not ripe. The IRS also argued that the Debtors had failed to state a claim because MSC II's status as a QSub was not "property" of the MSC II estate because MSC II "never had a right to claim, continue, or revoke" that status "either before or after it filed its bankruptcy petition" (App. at 81), and that no "transfer" of estate property occurred when BDI terminated its S-corp election and triggered the loss of MSC II's QSub status, (App. at 83-84).
Barden and BDI answered the Debtors' adversary complaint on February 28, 2011, and moved for judgment on the pleadings under Federal Rule of Civil Procedure 12(c). They contended that because a QSub has no separate tax existence, MSC II had no cognizable property interest in that status. They also argued that, because a subsidiary's QSub status depends entirely on elections made by its S-corp parent, even if MSC II's QSub status were a species of property, it was property that belonged to BDI and Barden.
The Debtors moved for summary judgment on March 16, 2011, and, on January 24, 2012, the Bankruptcy Court granted their motion and denied both the IRS's motion to dismiss and the Barden Appellants' motion for judgment on the pleadings. The Court held that MSC II's status as a QSub was the property of MSC II, and that, as such, it belonged to MSC II's bankruptcy estate. The Court therefore concluded that the revocation by non-debtor BDI of its status as an S-corp, and the resulting termination of MSC II's status as a QSub, were void and of no effect. ...