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Tax Payment on Behalf of Ponzi Scheme Inventor Must Be Returned by IRS.

(Parker Tax Publishing June 2016)

A district court held that the IRS had to return a tax payment made on behalf of a bankrupt company's owner. The court found that the payment was not made in good faith or for value. In re DBSI, Inc., 2016 PTC 191 (D. Idaho 2016).

Douglas Swenson was the founder and former president of DBSI Group of Companies (DBSI). DBSI was a conglomerate of real estate and non-real estate companies. In 2014, Swenson was convicted of multiple charges relating to DBSI's defrauding of investors. Swenson, and others who were also convicted, had publicly represented that DBSI was a profitable company and had a net worth in excess of $105 million when, to the contrary, DBSI's real estate and non-real estate business activities were universally unprofitable; DBSI's much-touted Master Lease investment product was losing approximately $3 million dollars a month. In addition, DBSI was relying on new investor funds, including investor money that DBSI represented would only be used in particular circumstances, to continue operations and pay returns to other DBSI investors. The conspiracy continued until DBSI filed for bankruptcy in November 2008.

DBSI Securities, a DBSI-related entity, sold tenant-in-common (TIC) investments as securities. FOR1031, a DBSI-related limited liability company taxed as an S corporation, sold TIC investments as real estate. Investors poured approximately $1 billion into DBSI's TIC investments. At the trial, investigators testified that DBSI's misrepresentations to investors dated back to at least 2004. In April of 2005, FOR1031 made a $14,115,000 payment to the IRS on Swenson's behalf for taxes he owed.

DBSI, Inc. went bankrupt after the Ponzi scheme was discovered. The company's bankruptcy trustee filed suit in an Idaho district court seeking to claw back the $14,115,000 payment to the IRS.

While the IRS conceded that the more than $14 million transfered to it on Swenson's behalf was intended to hinder, delay and defraud DBSI's creditors, it argued that it was entitled to keep the tax payment. The district court noted that, in the face of the IRS's concession that the funds paid to it by FOR1031 were fraudulent transfers, the trustee was entitled to avoid any transfer made within four years of filing the bankruptcy petition. On the other hand, the court said, the IRS could retain a lien on the transfers made to it within two years of the bankruptcy petition if it could prove that it received the transfers (1) in good faith, and (2) for value. Transfers made between two and four years before the bankruptcy petition are not avoidable, the court said, upon proof that the IRS took them in good faith and for reasonably equivalent value. Thus, the court observed, the common elements of the defense which the IRS had to establish in order to keep the payment were: (1) whether the transfer was made for reasonably equivalent value, and (2) whether the IRS received the transfer in good faith.

With respect to whether the transfer was made for reasonably equivalent value, both sides agreed that the test was the effect of the transfer on the bankruptcy estate from the perspective of the unsecured creditors; i.e., were the unsecured creditors better or worse off after the transaction?

The crux of the IRS's argument was that the owners of FOR1031 could have elected C corporation status, which would have rendered the company directly liable for its income taxes. Instead, the owners chose S corporation status (in which the members have personal tax liability for the business's income). The IRS's position was that, as a C corporation, FOR1031 would have paid $20 million in taxes on its declared income, while as an S corporation it paid only $17 million. The $3 million difference, according to this theory, was a savings which represents "value" to the debtor entity.

Alternatively, the IRS sought to treat the funds of FOR1031 as if they were the personal assets of Swenson, a "reverse veil piercing" which it justified on the grounds that the bankruptcy trustee had previously argued for alter ego treatment of the DBSI insiders' business entities.

The district court held that the IRS had to return the funds received as tax payments from FOR1031, except as to that amount already paid out as refunds. With respect to the IRS's main argument, the court found the argument unsupportable for three reasons. First, the court noted, at no time was FOR1031 subject to federal income tax at the entity level. Given that fact, FOR1031 realized no "savings" because it owed no taxes. Instead, the owners owed the taxes. Second, the court said, the argument that the entity could have chosen a legal status which would have subjected it to direct tax liability was speculative and meaningless. The fact is that FOR1031 did not chose C corporation status and its decision not to choose it could not, the court said, create "value" in any meaningful sense. Third, the court noted, given that the transfers were fraudulent, the transaction could not possibly leave the unsecured creditors better off.

With respect to the "reverse veil piercing" argument, the court noted that the IRS was treating the "alter ego" concept as though it were a mathematical equation; i.e., if A = B, then B = A. It is not that simple, the court said. Reverse piercing of the corporate veil is a "rarity," the court observed, and it is rarer yet in bankruptcy. According to the court, the trustee utilized the alter ego doctrine to get at the assets of DBSI business entities for the benefit of defrauded investor creditors. The court rejected the IRS's attempt to use a "reverse alter ego" theory to benefit the IRS at the expense of defrauded investor-creditors, saying it would be an unfair result.

The IRS also failed to convince the court that it was entitled to a presumption of good faith merely because it followed a regulation requiring it to process "commercially acceptable" payments. The legal reality of fraudulent transfers, the court said, is that they put certain burdens on the accepting party, burdens which cannot be erased by a "presumption" of good faith.

In the end, the court said that its decision was driven by equitable considerations which must have a place in any analysis concerning the disposition of fraudulent transfers. Every legal theory offered by the IRS to defend its right to retain this transfer seemed to court to ignore the fact that the money at issue was the proceeds of a widespread and devastating fraudulent scheme, stolen from scores of investors.

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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