Eleventh Circuit Holds S Corporation Election Is Not Property of the Bankruptcy Estate

For an S corp in chapter 11, the tax treatment of income and gain can directly affect creditor recoveries following an asset sale or other taxable transaction. An S corp generally is not subject to federal income tax at the corporate level. Instead, items of income, deduction, loss and credit generally pass through to its shareholders. If an S corp sells appreciated assets, the resulting gain generally passes through to and is taken into account by the shareholders for federal income tax purposes, even though the sale proceeds remain with the corporation. If S corp status is not in effect for the relevant taxable period, the corporation generally is subject to federal income tax on its taxable income as a C corporation.

The difference between pass-through taxation and taxation at the corporate level can create sharply competing interests in bankruptcy. Creditors may favor continued S corp treatment because tax imposed on shareholders does not reduce the debtor’s cash available to satisfy claims. Shareholders may favor ending S corp status if they otherwise would owe tax on corporate income or gain without receiving distributions from the debtor to fund the resulting tax liability.

The Eleventh Circuit addressed this conflict between a debtor corporation and its sole shareholder in Owoc.

The Bankruptcy and the S Election Dispute
John H. Owoc founded Vital Pharmaceuticals Inc. (VPX) in 1993 and, as its sole shareholder, consented to the corporation’s election to be treated as an S corp in 1997. VPX and several affiliates filed voluntary chapter 11 petitions in October 2022. A reconstituted board later removed Mr. Owoc as CEO and as a director, but he remained the debtor’s sole shareholder.

In July 2023, Mr. Owoc asked the bankruptcy court to confirm that the automatic stay did not apply to a revocation of the debtor’s S election or, alternatively, to grant relief from the Bankruptcy Code’s automatic stay so he could revoke the election. The bankruptcy court denied Mr. Owoc’s request. It reasoned that continued S corp treatment gave the debtor a valuable right to avoid federal income tax at the corporate level and therefore constituted property of the bankruptcy estate protected by the automatic stay.

Later that month, the debtor sold its assets. Under its chapter 11 plan, the debtor’s remaining interests subsequently vested in a liquidating trust. Mr. Owoc then sought relief from the automatic stay to permit him to terminate the debtor’s S corp status. The bankruptcy court denied that request as well. The district court later consolidated Mr. Owoc’s appeals and certified a direct appeal to the Eleventh Circuit.

The tax consequences gave both sides a substantial economic interest in the outcome. If the debtor remained an S corp for the relevant taxable period, income and gain recognized by the debtor generally would pass through to Mr. Owoc, potentially resulting in a corresponding federal income tax liability to him, while the debtor retained the cash generated by its asset sale. If S corp status ended for the relevant period, the debtor could instead become subject to federal income tax at the corporate level, reducing the assets available for distribution to creditors. The central substantive issue on appeal, however, was narrower: whether the debtor itself possessed a property interest in its S corp status that became property of the bankruptcy estate under section 541 and, therefore, whether the automatic stay prevented Mr. Owoc from seeking to revoke or terminate that status.

Why the Debtor’s S Corp Status Was Not Property of the Estate
Section 541(a)(1) of the Bankruptcy Code brings into the bankruptcy estate the debtor’s legal and equitable interests in property as of the commencement of the case. Section 541 does not enlarge the property interests the debtor held when the bankruptcy case began. As the Eleventh Circuit explained in Owoc, the trustee can take no greater rights than the debtor itself had.

Rather than asking only whether S corp status provided economic value to the debtor, the Eleventh Circuit looked to Subchapter S of the Internal Revenue Code to determine the rights the corporation and its shareholders possessed. An S election is valid only if all shareholders consent. An S election may be revoked only with the consent of shareholders holding more than one-half of the corporation’s shares on the date of revocation. S corp status also terminates if the corporation ceases to qualify as a small business corporation, which can occur, for example, when shares are transferred to an ineligible shareholder.

Although the corporation must file the revocation statement with the IRS, the Eleventh Circuit concluded that the “critical events” governing the creation and termination of S corp status largely fall within shareholder control. In the court’s view, the debtor therefore lacked the degree of control necessary to treat continued S corp status as its property.

The trustee argued that continued S corp treatment nevertheless conferred substantial value on the debtor. If the debtor could retain the proceeds of its asset sale while the tax attributable to the resulting income or gain passed through to Mr. Owoc, additional cash could remain available for creditor claims. The Eleventh Circuit held that this economic benefit did not give the debtor a legal or equitable interest in maintaining S corp status. The court reasoned that the debtor could not have a property interest in maintaining a tax status that its shareholders had legal authority to revoke or cause to terminate. The bankruptcy filing could bring the debtor’s existing property rights into the estate, but it could not convert the economic benefit of continued S corp treatment into a property right that the debtor did not otherwise possess. The court therefore held that the S corp election was not property of the bankruptcy estate. That conclusion also resolved the automatic stay issue: Because the election was not property of the estate, the automatic stay did not bar Mr. Owoc’s efforts to revoke or terminate the debtor’s S corp status on the ground that doing so would constitute an exercise of control over property of the estate. The court reversed and remanded for further proceedings.

The Eleventh Circuit expressly agreed with the Third Circuit’s reasoning in In re Majestic Star Casino, LLC, 716 F.3d 736 (3d Cir. 2013), which held that S corp tax status over which the debtor lacked the necessary control was not a legal or equitable interest of the debtor for purposes of section 541.

Net Operating Losses (NOLs) Distinguished
The trustee’s position invited a comparison to NOLs, a tax attribute that courts have treated as property of a bankruptcy estate. The Eleventh Circuit addressed the comparison directly and concluded that NOLs differ from S corp status in ways that matter under section 541.

The court explained that a debtor generally enters bankruptcy with a defined amount of NOLs generated by its own operations. Unlike S corp status, those losses are not subject to revocation by shareholders, and their potential value can often be estimated by reference to taxable income they may offset and, where a carryback is permitted, resulting tax refunds. The Eleventh Circuit cited Official Committee of Unsecured Creditors v. PSS Steamship Co. (In re Prudential Lines, Inc.), 928 F.2d 565, 573 (2d Cir. 1991), as an example. In Prudential Lines, the Second Circuit held that the debtor’s right to carry forward a $74 million NOL attributable to its prebankruptcy operations was property of the estate and upheld an injunction preventing the debtor’s parent from taking a worthless stock deduction that would have effectively destroyed the NOL carryforward.

A related decision illustrates the affirmative steps a bankruptcy fiduciary may take to realize NOL-related value. In In re Feiler, 218 F.3d 948, 955–56 (9th Cir. 2000), applying the tax law then in effect, a chapter 7 trustee successfully avoided a prebankruptcy election to waive an NOL carryback, restoring the estate’s ability to claim approximately $287,000 in tax refunds. The Ninth Circuit held that the trustee’s section 548 avoidance powers prevailed over the otherwise irrevocable tax election. The NOL cases therefore stand in contrast to Owoc: In those cases, the relevant tax value arose from rights held by the debtor or estate, rather than from rights controlled by the debtor’s shareholders.

The broader lesson extends beyond NOLs and S corps. Tax refunds, credits, elections and other tax-related rights can materially affect the economics of a restructuring. Whether the bankruptcy estate can preserve, use or monetize a particular item may depend on the nature of the rights associated with it and who holds those rights.

Practical Implications
Owoc has different implications for the principal participants in a restructuring. Across constituencies, however, the common theme is timing. Tax consequences and tax attributes should be evaluated while restructuring alternatives remain open, rather than after transaction terms have been fixed.

Debtors and Boards: Tax consequences should be considered as part of restructuring strategy before sale, financing or plan terms are fixed. For an S corp, the analysis should address whether S status is expected to continue through a taxable transaction, who can cause that status to change, when a revocation or termination would become effective, and how the competing tax outcomes would affect the corporation, its shareholders and creditor recoveries. It should also identify material NOLs, credits, refund claims and other tax attributes, as well as the deadlines and third-party rights that could affect them. Tax analysis should develop alongside the sale process, financing strategy and plan structure, not after those decisions have been made.

Trustees and Estate Fiduciaries: Potentially valuable tax attributes should be identified early enough to determine whether affirmative action is needed to preserve or realize their value for the estate. NOLs, refund claims and other tax attributes may represent meaningful sources of recovery. Prudential Lines and Feiler illustrate how bankruptcy law may be used to protect or recover tax-related value for an estate. Owoc, however, cautions against assuming that every favorable tax position is property of the estate simply because preserving it would benefit creditors.

Creditors and Committees: Projected recoveries should be tested against the tax assumptions on which they depend. If a sale or plan assumes that gain will pass through to shareholders, NOLs will offset taxable income, or a refund will be available to fund distributions, those assumptions can materially affect valuation and recoveries. Creditors should understand who holds the relevant tax rights, whether another party can alter the anticipated tax treatment, and whether the restructuring documents protect the assumptions on which the recovery analysis depends.

S Corp Shareholders: Potential pass-through tax exposure should be evaluated before the debtor recognizes significant income or gain. A shareholder may face substantial pass-through tax liability without receiving a corresponding distribution from the debtor. Owoc confirms that bankruptcy does not automatically transfer to the estate the shareholder rights governing revocation or termination of S corp status. At the same time, the decision does not alter the tax-law requirements governing shareholder consent, revocation, termination, effective dates and the corporation’s filing obligations.

Purchasers, Lenders and Plan Sponsors: Tax assumptions that are material to transaction economics should be tested and, where appropriate, addressed in the transaction documents. If the economics depend on continued S corp treatment, preservation of NOLs or a particular allocation of tax liabilities, the transaction documents should address the cooperation, elections, restrictions or other actions necessary to support the intended tax treatment.

Tax Deadlines: Bankruptcy proceedings do not suspend the need to address tax-specific deadlines. Owoc did not decide whether a change in the debtor’s S corp status ultimately could be made effective for the relevant period. By the time of the appeal, the ordinary statutory deadlines for making a revocation effective for the relevant tax year had passed. The Eleventh Circuit did not decide whether retroactive tax relief would ultimately be available. It left for remand issues concerning termination, laches and the resulting consequences for the sole shareholder, the estate and creditors.

Owoc reinforces the importance of addressing material tax issues while meaningful restructuring choices remain available. Tax considerations can shape transaction structure, creditor recoveries and the allocation of tax burdens among stakeholders. The restructuring analysis should therefore identify the relevant tax rights and attributes, determine who owns or controls them, and account for the deadlines governing their exercise.