TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Wednesday, July 16, 2014

Bankruptcy’s Corporate Tax Loophole

Diane Lourdes Dick (Seattle), Bankruptcy’s Corporate Tax Loophole, 82 Fordham L. Rev. 2273 (2014):

Imagine you are a company with a failing business that is drowning in debt. On the bright side, you also possess a very valuable asset. This asset is unique because, unlike most assets, if you liquidate the business through a Chapter 7 bankruptcy, it will be extinguished and its value will not be realized by any shareholders or creditors. On the other hand, even if you substantially liquidate the business using Chapter 11, you can, thanks to an extraordinary ambiguity in the law, preserve this valuable asset. Even better, you can direct the value of this asset to your preferred stakeholders—whether they are shareholders or creditors—rather than have the asset’s value allocated among stakeholders according to bankruptcy’s absolute priority rule. You can do this because you have the most information about this valuable asset and because bankruptcy law and courts effectively ignore its existence, leaving you to allocate its value as you see fit. What is this unique asset? Valuable tax attributes, including net operating losses and credit carryovers. This scenario is not purely hypothetical; Solyndra and Washington Mutual, among others, have effectively used Chapter 11 to divert the value of tax losses and credits to a select group of shareholders and creditors in contravention of bankruptcy‘s distributional norms. This Article recommends statutory revisions to the tax and bankruptcy laws to remove the unintended tax advantage and thus neutralize the tax consequences of corporate restructuring decisions.

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I wrote a couple of emails to the author, since I am meeting a tax prof (Leandra Lederman) and a congressional candidate in a few minutes for lunch and the topic might be good to bring up. If any reader has instant reactions, do let me know in the comments here or at

1. Is this the scheme? Acme Solar has 200 million in assets and 300 million in liabilities, so it goes into Chapter 11. All of the assets are NOL’s, so in liquidation, the creditors would get nothing. Acme proposes to give the creditors $10 million in cash (raised from the stockholders) and emerge with $200 million in NOLs and $0 in debt. The judge OK’s this, because the creditors do better than with liquidation. His decision cannot be appealed except on grounds of abuse of discretion, which would lose. Acme Solar can’t make any money in solar energy, so after coming out of Chapter 11, it buys an existing auto parts subsidiary of a car company, after raising more capital from its original shareholders and borrowing a lot. This is profitable because Acme Solar will not have to pay corporate income taxes for many years. They can borrow (perhaps even from the car company), because they also negotiate a an agreement under which the car company will buy all the auto parts.

Or, forget about the auto parts details--- Acme could just buy an existing profitable soap company, and never pay taxes.

2. There are three problems with this scheme, from the point of view of good government. A. The creditors get shut out. This is unfair and will lead to lenders being reluctant to lend in the future. B. The government loses the tax revenue, and the policy against NOL-trading has been thwarted. C. This makes it a sure-fire profitable strategy to go into some fashionable business like solar energy using government loan guarantees, credits, etc. with the plan of going bankrupt immediately. Thus, the government won’t even achieve its objective of promoting the particular fashionable business. (This works because the shareholders only have to put up limited capital, and they know they will get 100% ownership of the NOL’s later, which will be worth more than the lost capital.)

3. A key part of this is that Acme Solar is allowed to go into a different line of business after it emerges from Chapter 11 and still use its solar NOLs. Can this be blocked by statute?

4. A second part of this, tho perhaps not key, is that Acme is allowed to emerge with high leverage, so high that the new creditors really are pseudo-owners. Without that, the original shareholders have to come up with the new capital to buy the new line of business. Can’t existing statutes fight this, litigating over what “owner” means?

THis second part is not so important, because if the old shareholders include a corporation, like the private equity firm in Solyndra, the shareholder corporation can do the borrowing and can sell new shares, I suppose, thus avoiding the problem of new owners.

5. After skimming to the end of your article, I see that you suggest statutory changes. Could it be, though, that the problem is judicial interpretation, not the statutes? It sure sound that way to me--- problems like defining "assets" to omit tax assets, and other things that could be fixed by judicial opinion more easily than by statute.

Posted by: Eric Rasmusen | Jul 17, 2014 8:46:31 AM