An S Corporation and a Bankruptcy Trustee

The Kenrob case is a bankruptcy case and not a tax case. It presented such an unusual argument, though, that it caught my eye and my disbelief. Let’s talk about it.

Kenrob Information Technology Solutions, Inc. (Kenrob) was an S corporation. By agreement between the shareholders and the corporation, the corporation was obligated to reimburse the shareholders for the additional taxes attributable to its pass-through income. This is extremely common, although many times the agreement is not reduced to writing. The corporation distributed in April, 2007.  It did so again in April, 2008.

Kenrob goes into bankruptcy. The bankruptcy trustee wants the shareholders to pay the monies back, arguing that the disbursements were a fraudulent conveyance.

The trustee argues the following:

(1)   The only agreement that can be found between the corporation and the shareholders is a redlined agreement. A finalized, signed and dated copy cannot be found.

(2)   There was no consideration given by the shareholders for the distributions.

(3)   The value of the S election cannot be accurately measured. Had Kenrob been taxed as a C corporation, it may have taken different tax positions and strategies.

(4)   The agreement, if agreement there is, was made years before and is not binding.

The court decides the following:

(1)   The corporation and the shareholders have always followed an agreement. That it cannot be found does not mean that the agreement did not exist, especially since it has been fully performed on a continuous basis.

(2)   There was consideration to the corporation, as the shareholders did not take out all the distributable income. Rather they took out enough to pay taxes, leaving the excess with the corporation. This was of value to the company.

(3)   The court refused to engage in "what if” over corporate taxes.

(4)   There is no need for the agreement to be contemporaneous. The agreement was continuous and of lasting benefit.

The bankruptcy court decided in favor of the shareholders and that there was no fraudulent conveyance.

My take: A fraudulent conveyance. Really? As though the corporation would have paid no tax, or less tax, had it been taxed as a C rather than an S? The charge is so outlandish I have to wonder whether there were other factors – perhaps personal dislike – at play here. Otherwise that trustee’s driveway doesn’t quite reach the street.