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
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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
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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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
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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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
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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,'"
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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
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 lowincome 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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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.
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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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.