United States Court of Appeals
For the First Circuit
No. 03-2367
ALPHONSE MOURAD,
Petitioner, Appellant,
v.
COMMISSIONER OF INTERNAL REVENUE,
Respondent, Appellee.
ON APPEAL FROM THE DECISION OF
THE UNITED STATES TAX COURT
Before
Torruella, Circuit Judge,
Coffin, Senior Circuit Judge,
and Lynch, Circuit Judge.
Lester E. Riordan III for appellant.
Teresa E. McLaughlin, with whom Eileen J. O'Connor, Assistant
Attorney General, Richard Farber, and Kenneth W. Rosenberg, were on
brief for appellee.
October 20, 2004
COFFIN, Senior Circuit Judge. This case requires us to
consider whether a company's filing of a bankruptcy petition and
the appointment of a trustee automatically terminates the election
by its shareholders of "S Corporation" status under the Internal
Revenue Code. See 26 U.S.C. § 1361. Specifically at issue is a
nearly $200,000 income tax deficiency assessed against appellant
Alphonse Mourad stemming from the sale of assets of a corporation
of which he was the sole shareholder. The United States Tax Court
ruled that Mourad was personally liable for the tax because his
company, V & M Management, Inc., was an "S Corporation" whose gains
and losses are passed through to shareholders. See Mourad v.
Comm'r, 121 T.C. 1, 8 (2003). The court rejected appellant's
argument that V & M's bankruptcy filing had terminated the
company's S election, and it further concluded that appellant was
not entitled to a low-income housing credit to offset the tax
liability. On appeal, appellant challenges both the assessment and
the denial of the credit. As we find no legal or factual error, we
affirm.
I. Background
V & M Management owned and operated a 275-unit apartment
complex known as Mandela Apartments in Roxbury, Massachusetts, from
1981 until 1997. The property was sold in December 1997 for more
than $2.8 million as part of a reorganization plan developed by an
independent trustee after V & M filed a petition for reorganization
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under Chapter 11 of the Bankruptcy Code. For a number of years
before the bankruptcy filing, which occurred in January 1996, V &
M had been operated as an "S Corporation," a status available under
Subchapter S of the Internal Revenue Code, 26 U.S.C. §§ 1361-1379.
Subchapter S was added to the Tax Code to lessen the tax
burden on small businesses and to eliminate disincentives for them
to adopt the corporate form. Bufferd v. Comm'r, 506 U.S. 523, 524-
25 (1993); see also Durando v. United States, 70 F.3d 548, 551 (9th
Cir. 1995) ("Congress created S corporations to give small
businesses the benefits of the corporate form, such as limited
liability for shareholders, without the disadvantages of corporate
taxation."). When the shareholders of a qualified corporation make
a Subchapter S election, they switch from a multiple-level taxation
system to
a "pass-through" taxation system under which income is
subjected to only one level of taxation. . . . The
corporation's profits [and losses] pass through directly
to its shareholders on a pro rata basis and are reported
on the shareholders' individual tax returns. See
§ 1366(a)(1)(A).
Gitlitz v. Comm'r, 531 U.S. 206, 209 (2001) (citing Bufferd, 506
U.S. at 525).1
1
The income of corporations usually is subject to two levels
of taxation; it is taxed when earned by the corporation, and the
same income is taxed again when it is distributed to shareholders
in the form of dividends. See 26 U.S.C. §§ 301-385; Camilla Berit
Galesi, "Shareholders' Rights Regarding Termination of a Debtor
Corporation's S Status in a Bankruptcy Setting," 10 J. Bankr. L. &
Prac. 157, 159 (2001)["Shareholders' Rights"].
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Thus, for some number of years, V & M's income and any
offsetting expenses, including depreciation of the business's
property, were passed through to appellant. Appellant contends
that that arrangement – and the S corporation status that
authorized it – should have come to an end when the trustee took
over V & M and he no longer had control of the business. In the
alternative, he argues that, if he must bear the tax liability of
the property sale, he is entitled to a low-income housing credit
obtained by the trustee on behalf of the new owners of the
property.
The appellee, the Commissioner of the Internal Revenue
Service, maintains that V & M's S corporation election and the
pass-through system of taxation remained in effect for the 1997 tax
year, and that appellant does not qualify for a credit.2 We
address each of these issues in turn.
A. Termination of Subchapter S status
The Tax Code provides that a shareholders' election to take S
corporation status remains in effect until it is terminated under
26 U.S.C. § 1362(d). See 26 U.S.C. § 1362(c). Subsection (d)
identifies three ways in which termination may occur: (1) if more
than fifty percent of the corporation's shareholders vote to revoke
2
The trustee prepared and filed S corporation returns on
behalf of V & M for the years 1995 through 1999, and on the 1997
form reported that appellant had realized a gain of $2,088,554 from
the sale of Mandela Apartments. Appellant did not file individual
federal income tax returns for 1996 or 1997.
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the election; (2) if the business ceases to be a "small business
corporation," or (3) if the business's passive investment income
exceeds 25 percent of gross receipts for three consecutive years
(and the business earned profits each of those years). See id.
§§ 1362(d)(1), (2), (3).
Appellant asserts that section 1362(d)(2) is applicable here
and that V & M's S corporation status ended when it entered
bankruptcy because it no longer met the requirements of a "small
business corporation." Under the Tax Code, a small business
corporation must be a domestic corporation with fewer than 75
shareholders, all of whom must be individuals and none of whom may
be a nonresident alien, and it may have only one class of stock.
See id. § 1361(b). Appellant argues that, because the trustee took
control of the company for the benefit of its creditors, appellant
no longer was its real owner. This transfer of power, he
maintains, left V & M with new shareholders – the corporate
creditors – who were not individuals, and also generated more than
one class of stock because of the creditors' "different rights and
preferences."
We reject appellant's theory that his tenure as shareholder
ended when the trustee took over day-to-day operation of V & M. A
bankruptcy trustee steps into the shoes of the debtor - in this
case, the corporation - and the corporation and its shareholders
are "separate entities, including 'in respect of tax problems,'"
-5-
Durando, 70 F.3d at 552 n.9 (quoting New Colonial Ice Co. v.
Helvering, 292 U.S. 435, 442 (1934)); see also Bangor Punta
Operations, Inc. v. Bangor & Aroostook R.R. Co., 417 U.S. 703, 713
(1974) ("a corporation and its shareholders are deemed separate
entities for most purposes," but the corporate form may be
disregarded "where it is used to defeat an overriding public
policy"); Silverman & Sons Realty Trust v. Comm'r, 620 F.2d 314,
317 (lst Cir. 1980) (noting "general rule that corporation and
stockholders are considered separate entities for tax purposes").
Although appellant's equity interest in V & M may have been without
value by the time the bankruptcy filing occurred, see In re V & M
Mgmt., Inc., 321 F.3d 6, 8 (lst Cir. 2003), neither the trustee nor
the creditors displaced him as sole shareholder. Cf. Commodity
Futures Trading Comm. v. Weintraub, 471 U.S. 343, 353 (1985)
("[T]he trustee plays the role most closely analogous to that of a
solvent corporation's management."); In re Sanders, 969 F.2d 591,
593 (7th Cir. 1992) ("[A] bankruptcy trustee succeeds only to the
title and rights in property that the debtor had at the time [it]
filed the bankruptcy petition.").
Bankruptcy law, moreover, explicitly provides that any income
of the estate in a bankruptcy case, with certain exceptions not
asserted as relevant here, "may be taxed only as though such case
had not been commenced," see 11 U.S.C. § 346(c)(1), reinforcing the
view that a Chapter 11 bankruptcy filing does not change the tax
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relationship between a debtor corporation and its shareholders.
This conclusion is further buttressed by the scant case law that
exists. In In re Stadler Assocs., Inc., 186 B.R. 762 (Bankr. S.D.
Fla. 1995), the sole shareholder of an S corporation that had filed
a petition for relief under Chapter 7 of the Bankruptcy Code argued
that the bankruptcy filing had terminated the debtor's S
corporation status. The bankruptcy court disagreed, holding that
termination was limited to the three methods set out in section
1362(d) and that none of those had occurred. See id. at 764.
Other courts, while not directly considering whether a
bankruptcy filing automatically ends Subchapter S status,
implicitly have adopted Stadler's view in the course of discussing
whether shareholders may choose to terminate S status pursuant to
section 1362(d) when a bankruptcy filing is anticipated. See,
e.g., In re Bakersfield Westar, Inc., 226 B.R. 227, 235-37 (9th
Cir. BAP 1998); In re Trans-Lines West, Inc., 203 B.R. 653, 659-60
(Bankr. E.D. Tenn. 1996); see also "Shareholders' Rights," 10 J.
Bankr. L. & Prac. at 176-80. Such an inquiry would be unnecessary
if bankruptcy automatically effected termination.
Having concluded that V & M did not convert to a standard C
corporation by virtue of a change in its shareholders, we likewise
reject appellant's assertion that the company lost its small
business classification based on a change in the classes of stock.
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There is no evidence in the record that shareholders other than
appellant existed or exercised rights different from his.
Although we do not face in this case the question whether
shareholders should be permitted to terminate S status pursuant to
section 1362(d) when a bankruptcy filing is imminent or has
occurred, and thus need not consider the competing equities at
issue, we recognize the logic in appellant's contention that it is
unfair to assess tax liability on shareholders who do not receive
the income on which they are obliged to pay the tax. See
"Shareholders' Rights," 10 J. Bankr. L. & Practice at 157; Richard
A. Shaw, "Taxing Shareholders on the Income of an S Corporation in
Bankruptcy," 1 No. 6 Bus. Entities 40, 47 (1999), 1999 WL 1419055,
at *47 (criticizing courts for disallowing new tax elections, which
has the effect of "sever[ing] the tax burden from the assets
without the consent of the shareholders," and noting that this
"abuses the economics of both the tax and the bankruptcy systems");
cf. In re Forman Enters., Inc., 281 B.R. 600, 609-610 (W.D. Penn.
2002) (S corporation shareholders not unjustly enriched by
retaining tax refunds for themselves rather than turning them over
to chapter 7 trustee for distribution to debtor's creditors).
Here, appellant did not attempt a statutory revocation of the
S corporation election. Moreover, the record indicates that he was
personally liable for V & M's debts. See Mourad, 121 T.C. at 6;
Appendix at 336. To the extent that the proceeds from the sale of
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the apartment complex were applied to the company's debts,
therefore, appellant received benefit along with the tax burden.3
Accordingly, we conclude that V & M remained an S corporation
following its entry into bankruptcy and that appellant properly was
assessed pass-through tax liability on the asset sale.
B. Availability of the Low-income Housing Credit
Appellant argues that if he is to be assessed taxes on the
income generated by the sale of the Mandela Apartments property, he
is entitled to the low-income housing credit available for such
projects under 26 U.S.C. § 42.4 Under the statute and its related
regulations, see 26 C.F.R. § 1.42-1T, a detailed series of steps
must be followed by a property owner seeking the credit, none of
which appellant completed. The trustee, however, did help to
secure the credit on behalf of the new owners of the Mandela
Apartments, and appellant argues that equity entitles him to
utilize the credit to offset his tax liability.
3
Appellant states in his brief that "[t]he proceeds from the
disposition of the corporation's assets were paid directly to a
creditor's trust rather than the corporation."
4
Section 42 was added to the Internal Revenue Code in 1986
to stimulate the production of low-income rental housing. See
"Joint Committee on Taxation's General Explanation of the Tax
Reform Act of 1986" (Blue Books), Title II, Section E(2) ("Congress
believed a more efficient mechanism for encouraging the production
of low-income rental housing could be provided through the low-
income rental housing tax credit."); Oti Kaga, Inc. v. South Dakota
Hous. Dev. Auth., 342 F.3d 871, 875 (8th Cir. 2003) (section 42's
tax credit allocation program "encourages investment in low-income
housing projects").
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This argument is entirely lacking in foundation. So far as
the record on appeal shows, the tax credits granted to the project
were obtained for 1998. See Appendix at 169 ("Certificate of
Binding Commitment" from the Massachusetts Department of Housing
and Community Development for "$1,000,000 in 1998 Tax Credits for
Mandela Homes," granted under the "Low-Income Housing Tax Credit
Program as authorized by Section 42(h)(1)(c) of the Internal
Revenue Code of 1986"). The tax liability at issue in this case is
for 1997. Appellant thus appears to be seeking to use a tax credit
that does not exist. The record does not permit the conclusion
that, had the trustee sought to obtain a tax credit for 1997, it
would have been granted.5 In these circumstances, we find no error
in the district court's conclusion that appellant is responsible
for the full income tax liability generated from the sale of
Mandela Apartments.
Affirmed.
5
We note that appellant states in his brief that V & M
qualified for the tax credit in 1994, two years before the trustee
took over operation of the business. It appears that no effort to
secure the credit was made until the trustee did so in anticipation
of the change of ownership that occurred in December 1997.
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