Clawback from IRS of Payment by Ponzi Schemers

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In the case of Zazzali v. United States, the 9th Circuit has affirmed a lower court decision allowing the trustee in a bankruptcy of company that ran a Ponzi scheme to require the IRS to pay the money paid to it for taxes back to the bankruptcy estate for distribution to other creditors of the estate. The case involves Idaho’s Uniform Fraudulent Transfer Act as applicable through Bankruptcy Code section 544(b)(1), as well as the sovereign immunity provision of Bankruptcy Code section 106(a)(1). To win, the trustee needed to show that outside of bankruptcy an unsecured creditor could avoid the same transfer and that the sovereign immunity provision in the bankruptcy code did not prevent the ordering of a repayment from the government.

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The company that engaged in the Ponzi scheme was set up as an S Corporation. While operating and while running the Ponzi scheme, it made tax payments on behalf of its shareholders. It paid the IRS over $17 million during the years of the scheme and the primary beneficiaries of the payments were the two principal officers of the corporation. The IRS ultimately refunded to these two men over $3.6 million in claimed overpayments on their individual returns.

When the corporation filed bankruptcy and a trustee was appointed, the trustee began bringing fraudulent transfer actions to bring money into the estate for the benefit of the unsecured creditors. In addition to pursuing the company insiders, the trustee went after the IRS and 25 states to whom taxes were paid. The appeal only involves the IRS.

The trustee used both the fraudulent transfer provisions of Bankruptcy Code 544(b)(1) and 548. Section 548 is broader in scope but more limited in time. Under that provision, the trustee recovered $58,000 from the IRS paid within two years of the filing of the petition and the IRS did not contest that claim. Section 544(b)(1), which relies on the state provision for fraudulent transfers, allows the trustee to go back four years from the petition, and that was where the high dollar transfers occurred.

The IRS argued that Congress had not waived sovereign immunity with respect to the 544(b)(1) claim. The Seventh Circuit, in an almost identical case, ruled for the IRS in the case of In re Equipment Acquisition Resources, Inc., 742 F.3d 743 (7th Cir. 2014). The 9th Circuit reaches a different conclusion.

Section 106 lists the bankruptcy code sections for which sovereign immunity is waived. Section 544 is one of those sections. The 9th Circuit holds that the waiver in section 106 is absolute and gets past the IRS concern that the type of fraudulent conveyance at issue here is one derived from a state statute. The view of the IRS is that because the trustee here relied on 544(b)(1), and through it Idaho’s Uniform Fraudulent Transfer Act, the government’s sovereign immunity precludes a claim based on state law. To get past the IRS argument, the 9th Circuit, affirming the decisions of the district court and bankruptcy court below, looks at the bankruptcy code as a whole and how the two provisions at issue here fit into the overall scheme.

The sovereign immunity provision at issue here was enacted after the enactment of section 544. This suggests that Congress knew what it was doing when it put 544 into the list of provisions for which sovereign immunity was waived and did not back into this situation.

The 9th Circuit also found that the IRS interpretation of section 106 and the interplay of the sovereign immunity provision there with the fraudulent transfer provision in 544 would nullify a portion of the statute. Using a rule of statutory construction, the 9th Circuit found that this interpretation should be avoided if possible, and here it is possible if the waiver of sovereign immunity is read broadly.

The 9th Circuit acknowledged that its opinion is at odds with the only other circuit court opinion and it writes further to explain why its interpretation is the better one. (Perhaps anticipating that the circuit split will result in Supreme Court review.) The 7th Circuit rests its opinion in the Equipment Acquisition case, upon the ground that private creditors could not use the state fraudulent conveyance statute to pry money out of the federal government. It viewed the trustee as standing in the shoes of the state creditors and did not believe that the broad statement in section 106 was intended to change non-bankruptcy law in such a way that allowed the trustee to have state law powers no private creditor had outside of bankruptcy.

The 9th Circuit finds that this is exactly what Congress intended when it passed the broad waiver of sovereign immunity. It recognized the unique position of the bankruptcy trustee and the need to recover money for the bankruptcy estate in a federal proceeding, albeit one based upon state law.

In addition to the argument regarding sovereign immunity, the IRS also argued, in line with the reasoning of Equipment Acquisition, that the 9th Circuit’s interpretation ran afoul of the Appropriations Clause and the Supremacy Clause. These provisions would potentially stop a private creditor outside of bankruptcy even if sovereign immunity did not. The 9th Circuit says no Appropriation Clause violation exists because the trustee is not taking money out of the Treasury but rather recovering money where a transfer is “voidable under applicable law.” With respect to the Supremacy Clause concerns, the 9th Circuit finds that because bankruptcy is a federal cause of action, this situation is not a state wielding power over the federal government.

I do not know if the IRS will pursue this issue into the Supreme Court but would not be surprised if it did. There is a fair amount of money in this case and these types of cases sadly come up with some regularity. The result here is not one that bothers me from an equitable standpoint. It does not seem right for the IRS to keep money stolen from individuals where the tax is essentially a tax on the ill-gotten gains. I feel better if the money goes back to the individuals who suffered the loss and the IRS does not receive what amounts to a type of windfall. Sometimes victims or agencies representing the victims make constructive trust arguments in these types of situations. Whatever the argument, it makes sense to try to get the money back to the victims if possible. I hope that the litigation does not cause all of the money to end up in the hands of the lawyers to the exclusion of the victims.

 

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