Another Clawback of Money Paid to the IRS

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Last year, I wrote about a Ponzi scheme case, Zazzali v. United States in which the 9th Circuit allowed a bankruptcy trustee to recover money paid to the IRS by the perpetrator of the scheme prior to the filing of the bankruptcy petition. The payments could not be recovered for the estate using the preference provisions because of the timing and the nature of the payments; however, the court allowed the trustee to pull the money away from the IRS and into the bankruptcy estate using a combination of state remedy and waiver of sovereign immunity.

The 9th Circuit decision represented a split with the 7th Circuit, which had held in In re Equipment Acquisition Resources, Inc., 742 F.3d 743 (7th Cir. 2014) that a clawback under similar circumstances was not permitted under the applicable provision of the bankruptcy code. The last entry shown for the Supreme Court docket in Zazzali is Justice Kennedy granting the motion to extend the time to file a petition for a writ of cert. The motion was granted on April 9, and extended the deadline until May 18. The IRS regularly obtains extensions of time when considering whether to appeal. Here, it appears it decided not to appeal. Many reasons could exist for the decision not to appeal. In the meantime, the IRS lost another case with this issue, McClarty v. Hatchett, Case No. 17-451163-MBM (E.D. Mich. 2018) and has filed an appeal to the 6th Circuit in that case. So, the decision not to seek cert in Zazzali does not represent a concession of the issue by the IRS.

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At issue in these cases is the interpretation of B.C. 544(b)(1) and 548 and the interplay of one or both of these sections with B.C. 109 and the waiver of sovereign immunity. Where the Zazzali case involved a Ponzi scheme, the Hatchett case involves the use of funds belonging to the debtor, Laurestine Hatchett, to pay the federal tax liabilities of her husband. In 2014 the debtor’s children were appointed co-conservators of for her because of her disability which prevented her from managing her affairs. Mrs. Hatchett’s husband and her daughter were appointed her co-guardians. In 2015 real property was sold for over $300,000 which debtor owned 50/50 with her son. She received net proceeds of $122,827. The son turned the proceeds over to the father who deposited them into an account in the name of his law firm. A major portion of the proceeds were then used to pay federal taxes owed by Mr. Hatchett (the father) or his law firm.

On April 6, 2017, an involuntary chapter 7 petition was filed against debtor. While persons going into bankruptcy file almost all bankruptcy cases voluntarily, under the right circumstances creditors can “take” a person into bankruptcy involuntarily and that happened here. I did not go to the bankruptcy case to try to determine why; however, the involuntary bankruptcy was accepted by the bankruptcy court shortly after it was filed and a trustee was appointed to administer the bankruptcy estate. The trustee has a duty, and a financial interest because of the ways fees are paid, to find and bring back into the estate all money possible. The trustee looked at the transaction described above and determined that it fit the provisions of fraudulent transfer. The IRS in these situations has not participated in the fraudulent transfer other than to accept and apply funds as directed by the person making the payment. Based on the facts here, Mr. Hatchett’s transfer of his disabled wife’s funds to pay his personal or business tax liability certainly appears to be an improper conversion of her funds.

The IRS defended the action by arguing that sovereign immunity protected it from this action. Essentially, the IRS made the same arguments it previously made in Zazzali and Equipment Acquisition Resources.

The bankruptcy court started with an explanation of the applicable fraudulent transfer law and the two provisions in the bankruptcy code at issue here:

Fraudulent transfers can be avoided under two different sections of the Bankruptcy Code:

11 U.S.C. § 548, which creates a body of federal fraudulent transfer law, and 11 U.S.C. § 544(b), which gives the trustee power to avoid a fraudulent transfer by the debtor if the transfer would be voidable by one of the debtor’s creditors under state law. Specifically, § 544(b)(1) permits a trustee to step into the shoes of an actual creditor who has a fraudulent transfer remedy under other “applicable law” (i.e. a state fraudulent transfer statute) and exercise that creditor’s remedies on behalf of the bankruptcy estate. 11 U.S.C.§ 544(b)(1) provides, in relevant part, that a “trustee may avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor that is voidable under applicable law by a creditor holding an unsecured claim. . .

The key difference between an action under § 548 and an action under § 544(b)(1) is the reach-back period. Section 548, captures only transfers made in the two years preceding the filing of the bankruptcy. Section § 544(b)(1) looks to the specific state statute’s reach-back period, which is generally longer than two years. Thus, a bankruptcy trustee seeking to recover transfers made more than two years prior to the filing of the bankruptcy must file an action under 544(b)(1).

The court then discussed the interplay of sovereign immunity with the fraudulent transfer provisions since the IRS argument in the case was that sovereign immunity prevented the relief requested. BC 106 sets out the waiver of sovereign immunity and that section lists all of the bankruptcy code sections that waive immunity. Included in that list are 544 and 548. The court notes that the plain language of the statute includes the statutes at issue within the waiver of sovereign immunity citing favorably to the Ninth Circuit’s decision in Zazaali. The IRS argues that while 544 waives sovereign immunity it does not waive it for suits that could not be brought outside of bankruptcy. Since no waiver exists outside of bankruptcy for a creditor to sue the IRS under a state based fraudulent transfer statute, Congress could not have intended to allow such a suit by the trustee in a bankruptcy case.

The bankruptcy court rejected the IRS interpretation and followed the reasoning In Zazzali stating:

The Ninth Circuit’s broad reading of section 106 was bolstered by the fact that section 106(a)(1) was enacted after section 544(b)(1). As a consequence, when Congress passed 106(a)(1), it was, presumably, well aware of the fact that section 544(b) allowed a trustee to bring claims derived from applicable state law, a power that had been included in the Bankruptcy Code at the time the Code was enacted in 1978, and had existed under the Bankruptcy Act of 1898.

The court also cited the reason for the fraudulent conveyance statute in support of its decision:

It is undisputed that Debtor does not have a tax liability to the IRS. In its fraudulent transfer action under § 544(b)(1), the Trustee is simply seeking to recover money that Debtor should have used to pay her own creditors. In abrogating governmental immunity for suits brought under § 544, Congress’s clear intention was that the fraudulently transferred property must be recovered for the benefit of Debtor’s creditors, regardless of the status of the recipient of the fraudulent transfer.

The court then addressed additional defenses raised by the IRS. The IRS based the first of these defenses on BC 106(a)(5) which provides:

Nothing in this section shall create any substantive claim for relief or cause of action not otherwise existing under this title, the Federal Rules of Bankruptcy Procedure, or nonbankruptcy law.

In rejecting this argument the court finds that the substantive claim is permitted under otherwise existing law, specifically BC 544(b)(1).

It then moves to the IRS argument that the federal law in title 26 preempts the state law fraudulent conveyance action. The IRS arguments is that “state law is preempted where state law attempts to regulate conduct in a field that ‘Congress intended the Federal Government to occupy exclusively.'” In rejecting this argument the bankruptcy court finds that the argument of the IRS does not apply since the suit here has nothing to do with the payment or collection of taxes from Laurestine Hatchett. The fraudulent conveyance suit seeks to bring money into the bankruptcy estate wrongfully taken from her. The court focuses on her and not on the payment of taxes by her husband.

Finally, the court rejects the IRS argument that IRC 7422 prohibits the repayment of this money. IRC 7422 provides:

No suit prior to filing claim for refund.–No suit or proceeding shall be maintained in any court for the recovery of any internal revenue tax alleged to have been erroneously or illegally assessed or collected, or of any penalty claimed to have been collected without authority, or of any sum alleged to have been excessive or in any manner wrongfully collected, until a claim for refund or credit has been duly filed with the Secretary, according to the provisions of law in that regard, and the regulations of the Secretary established in pursuance thereof. The bankruptcy court says that 7422 has no applicability to this situation.

The IRS will continue its arguments on this issue into the circuit court. If it loses again, I expect it will either seek to take this case to the Supreme Court or it will give up on this argument. In the meantime trustees will look for payments to the IRS by debtors in bankruptcy that satisfy the tax debt of someone other than the debtor.

 

Comments

  1. Norman Diamond says:

    “The IRS regularly obtains extensions of time when considering whether to appeal.”

    Yes, but only in Tax Court.

    “Here, it appears it decided not to appeal.”

    No, the DOJ decided not to appeal. We don’t know if the IRS had an opinion on the matter. The DOJ does not have to care if the IRS had an opinion on the matter or not.

    Off topic, but I cannot help wondering. If the thief used stolen money to buy dinner at a restaurant, could the victim’s bankruptcy trustee compel the restaurant to refund the cost of meal? And compel the server to return the tip?

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