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Sovereign Immunity Did Not Bar Bankruptcy Trustee's Action to Avoid Debtor's Fraudulent Tax Payments

(Parker Tax Publishing October 2017)

The Ninth Circuit Court held that sovereign immunity did not preclude a bankruptcy trustee from bringing an action under a state fraudulent transfer statute to avoid an S corporation debtor's payment of federal income taxes on its shareholders' behalf. In reaching the decision, the Ninth Circuit declined to follow In re Equipment Acquisition Resources, Inc., 2014 PTC 70 (7th Cir. 2014), where the Seventh Circuit reached the opposite conclusion in holding that the waiver of sovereign immunity in the Bankruptcy Code did not extend to a derivative state law claim. In re DBSI, Inc., 2017 PTC 404 (9th Cir. 2017).

DBSI, Inc. was a commercial real estate developer. It was involved in an illegal Ponzi scheme through which, in its last two years of operation, it purportedly lost $3 million per month and used new investor funds to meet existing obligations. Several of the company's insiders were indicted in May 2013 and later convicted of various fraud crimes.

As an S corporation, DBSI made tax payments on behalf of its shareholders. Between 2005 and 2008, DBSI paid the IRS approximately $17 million in income taxes on behalf of its shareholders. Most of the payments were made on behalf of Doug Swenson and Thomas Var Reeve, two of DBSI's largest shareholders. The IRS ultimately refunded approximately $3.6 million to Swenson and Reeve in claimed overpayments of their individual tax liabilities.

DBSI filed for bankruptcy in 2008. In 2010, a plan of liquidation was confirmed and James Zazzali was appointed as trustee. Under 11 U.S.C. Sec. 544(b)(1), a trustee can avoid any transfer by a debtor if the transfer is voidable under state law by an unsecured creditor. In an avoidance action, the trustee takes the shoes of an unsecured creditor in determining whether the transfer can be avoided; any reason that might prevent such a creditor, including the statute of limitations, estoppel, waiver, or any other defense, also applies to the trustee. The waiver of sovereign immunity in 11 U.S.C. Sec. 106(a)(1) applies for any governmental unit, including the IRS, with respect to Sec. 544(b)(1).

Zazzali sought to avoid the tax payment as a fraudulent transfer under Sec. 544(b)(1) and Idaho's Uniform Fraudulent Transfer Act (UFTA). He brought an adversary proceeding to recover the allegedly fraudulent transfers, including the $17 million in payments to the IRS, on behalf of shareholders. The government argued that Congress had not abrogated sovereign immunity with respect to the Sec. 544(b)(1) underlying state law cause of action, and therefore, there was no unsecured creditor who could sue the government under Idaho's UFTA.

A bankruptcy court concluded that Sec. 106(a)(1)'s waiver of sovereign immunity permitted the Zazzali's suit to proceed. The government appealed the bankruptcy court's ruling to the district court. While the government's appeal was pending, the Seventh Circuit decided In re Equipment Acquisition Resources, Inc., 2014 PTC 70 (7th Cir. 2014), which analyzed the identical issue before the district court. The Seventh Circuit came to the opposite conclusion as the bankruptcy court, and held that Sec. 106(a)(1)'s waiver of sovereign immunity does not extend to Sec. 544(b)(1)'s derivative state law claim. Nonetheless, the district court was unpersuaded by the Seventh Circuit's reasoning, and affirmed the bankruptcy court's ruling. Thus, the district court ruled in favor of Zazzali and avoided approximately $13.4 million, equal to the tax payments less the amount that had been refunded to Swenson and Reeve. The IRS appealed to the Ninth Circuit.

The Ninth Circuit affirmed the district court's decision, holding that the waiver of sovereign immunity in Sec. 106(a)(1) applied to the trustee's claim under Sec. 544(b)(1). First, the court looked at the plain language of the statute and concluded that the effect of Sec. 106(a)(1) is to completely abolish sovereign immunity with respect to Sec. 544. Second, the court noted that Sec. 106(a)(1) was enacted after Sec. 544(b)(1). In the court's view, when Congress waived sovereign immunity with respect to Sec. 544, it understood that Sec. 544(b)(1) codified a trustee's powers to invoke state law. According to the court, Congress knowingly included state law causes of action within the category of suits to which a sovereign immunity defense could no longer be asserted. Third, the court reasoned that the IRS's argument would essentially nullify Sec. 106(a)(1). Concluding that the IRS was asking it to construe Sec. 106(a)(1) in a way that would ignore its plain text, the Ninth Circuit declined to adopt such a reading of the statute.

The Ninth Circuit recognized that its decision conflicted with the Seventh Circuit's opinion in In re Equipment Acquisition Resources, Inc. The Ninth Circuit then discussed its reasons for disagreeing with that decision. The Seventh Circuit applied a two-step analysis to determine (1) whether there was a waiver of sovereign immunity, and (2) whether the substantive law provided an avenue for relief. The Seventh Circuit acknowledged that Sec. 106(a)(1) clearly provided a waiver of immunity. However, the Seventh Circuit determined that the applicable Illinois fraudulent transfer law did not provide an avenue for relief because any unsecured creditor attempting to bring such a claim against the IRS in Illinois would be barred by the government's sovereign immunity. The Seventh Circuit concluded that Sec. 106(a)(1) did not alter the substantive requirements of Sec. 544(b) merely by stating that the federal government's authority was abrogated "with respect to" that provision.

The Ninth Circuit focused on the second prong of the Seventh Circuit's analysis and considered whether Sec. 544(b)(1) and Idaho's fraudulent transfer statute provided an avenue for relief. The Ninth Circuit gave two reasons why both the Bankruptcy Code and Idaho law envisioned the government as a potential defendant. First, the fact that Congress enacted the Sec. 106(a)(1) waiver of immunity logically meant that both Sec. 544(b)(1) and the derivative state law provided a substantive cause of action against the government. It would make no sense, the court reasoned, for Congress to waive sovereign immunity as to a claim which could not be brought against the government. Second, under both the Bankruptcy Code and Idaho law, debtors and creditors are defined to include the government. These statutory definitions further demonstrated to the Ninth Circuit that Sec. 544(b)(1) and the derivative law on which it relies contemplate suits against the government. The Ninth Circuit concluded that under the Seventh Circuit's approach, a substantive cause of action against the government would exist only if Congress also waived sovereign immunity with respect to the particular applicable law under Sec. 544(b)(1). The Ninth Circuit found that to impose such a requirement would be contrary to the plain text of Sec. 106(a)(1).

Additionally, with respect to Constitutional concerns raised by the Seventh Circuit's decision, the Ninth Circuit disagreed with the suggestion that a state law claim would potentially run afoul of the Appropriations Clause and the Supremacy Clause. Finally, the Ninth Circuit offered additional supporting reasons for its decision based on principles of equity and the policy of the Bankruptcy Code.

For a discussion of bankruptcy estates, see Parker Tax ¶16,101.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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