The fact scenario is this. An S corporation pays its own taxes each year. Then it files bankruptcy. So, the bankruptcy trustee sues the IRS for recovery of those tax payments as fraudulent transfers. It does so under two different sections of the Bankruptcy Code:
(i) Under § 548, for payments within two years before bankruptcy (this is the Bankruptcy Code’s own fraudulent transfer law), and
(ii) Under § 544(b)(1), for payments beyond two years but within the statutes of limitations established by state law—typically, four years (this subsection incorporates state fraudulent transfer laws into the Bankruptcy Code).
The case is new: Zazzali v. USA (In re DBSI, Inc.), Case No. 16-35597 (9th Cir., Decided August 31, 2017), and the basic facts are as noted above. The trial court rules, on summary judgment, in favor of the Trustee on all counts, and the IRS appeals.
The appeal, however, is limited. As to payments received within two years before bankruptcy, the IRS acknowledges, under § 548, (i) that such payments qualify as fraudulent transfers, and (ii) the absence of substantive defenses. Accordingly, the IRS voluntarily pays back all tax payments received from the debtor within two years before bankruptcy.
But as to § 544(b)(1) claims for payments beyond two years, the IRS continues to contest the Trustee’s claims. The contest, however, is limited to a single issue: whether the “actual creditor” requirement of § 544(b)(1) is satisfied.
Critical Facts in Zazzali v. USA
Here are some facts the Ninth Circuit identifies as critical in this case.
The S corporation fact is critical because such corporations “do not themselves pay taxes” on their own income. Instead, the corporation’s tax liability “is passed through to the corporation’s shareholders.” So, payment of “its own taxes” is a misnomer: such payments are, actually, of someone else’s liability. And the trial court ruled that the IRS “did not receive” the tax payments “for value”
The S Corporation debtor (DBSI, Inc.) engaged in “the acquisition, development, management, and sale of commercial real estate properties” through “an illegal Ponzi scheme.” As such, the Trustee is prosecuting claims in this case for “actual intent to hinder, delay, or defraud” creditors, under both § 548 and § 544(b)(1). The trial court ruled that the IRS did not receive the tax payments “in good faith.”
The Remaining “Actual Creditor” Issue
The IRS insists that it is not liable for § 544(b)(1) claims under state fraudulent transfer laws because of this language in § 544(b)(1):
–the trustee may avoid a transfer under state fraudulent transfer laws “that is voidable by a creditor holding an unsecured claim.”
This § 544(b)(1) language is commonly construed to mean that § 544(b)(1) claims require “the existence of an actual creditor who could avoid the transfer” outside of bankruptcy. The Ninth Circuit explains in Zazzali v. U.S.A.: “if the actual creditor could not succeed for any reason . . . then the trustee is similarly barred and cannot avoid the transfer.”
Sovereign immunity provides that a government cannot be sued, unless such immunity is explicitly waived. The Bankruptcy Code, in § 106(a)(1), explicitly waives sovereign immunity for claims under both § 548 and § 544.
The IRS insists that, while § 106(a)(1) may waive sovereign immunity for the trustee to pursue § 544(b)(1) claims, it does not eliminate the “actual creditor” requirement. And there is no “actual” unsecured creditor who could avoid the transfer outside of bankruptcy: every unsecured creditor who might try to do so would be barred, outside of bankruptcy, by sovereign immunity.
A Circuit Split
The IRS arguments in Zazzali v. U.S.A. rely upon a 2014 ruling by the Seventh Circuit Court of Appeals. The Seventh Circuit case involves fraudulent transfer claims under § 544(b)(1) to recover tax payments made by a now-bankrupt individual on tax obligations owed by his corporations. The case is In re Equipment Acquisition Resources, Inc., 742 F.3d 743 (7th Cir. 2014), where the Seventh Circuit describes the § 544(b)(1) “actual creditor” issue this way:
–the question is whether a trustee can bring a § 544(b)(1) claim “even though, outside of bankruptcy, sovereign immunity would bar a regular creditor from doing so.”
Then the Seventh Circuit rules in the negative. It declares that the § 106(a)(1) waiver of sovereign immunity does not affect the § 544(b)(1) “actual creditor” requirement. Accordingly, the Trustee cannot pursue a claim against the IRS under § 544(b)(1).
The Seventh Circuit’s decision relies upon a two-step process for determining liability of a federal agency, which the U.S. Supreme Court utilizes in FDIC v. Meyer, 510 U.S. 471 (1994). The second step of that process is “whether the source of substantive law” (i.e., the state fraudulent transfer law) “provides an avenue for relief against the IRS.” The Seventh Circuit rules that:
–§ 544(b)(1) requires a showing that an actual creditor exists; and
–“there is no question that no creditor exists in this case” who could bring a fraudulent transfer against the IRS outside of bankruptcy.
The Seventh Circuit describes this “actual creditor” issue as one “of first impression for any circuit court of appeals.” And its opinion acknowledges that “we diverge from all of the bankruptcy and district courts” who have considered the issue “in the context of the federal government.” For such diverging rulings, the Seventh Circuit cites, in footnote 3, opinions from U.S. bankruptcy and district courts in Southern Florida, Middle Florida, Eastern Pennsylvania, and Maryland.
The Seventh Circuit’s ruling on this point is now the law of the land in a wide swath of districts across the Midwest: covering all of Illinois, Indiana and Wisconsin.
[Editorial Note: You’ve gotta admire the Seventh Circuit for standing up for a rule of law it believes is correct, even when everyone else is going the other way!]
—Zazzali v. USA (9th Circuit)
The Ninth Circuit is the second circuit court of appeals to tackle the § 544(b)(1) “actual creditor” issue for recovering tax payments. It does so in the Zazzali v. USA case. And the Ninth Circuit reaches an exactly-opposite conclusion from that of the Seventh Circuit. Here is the Ninth Circuit’s decision summary:
–§ 106(a)(1) “unambiguously abrogates” sovereign immunity, which abrogation is “absolute with respect to” § 544(b)(1) and “necessarily includes the derivative state law claim” on which it is based.
As to rulings by other courts, the Ninth Circuit’s opinion says, in footnote 11, that the Seventh Circuit “is the only other circuit to have addressed” this issue “in a published opinion.” And it asserts that “bankruptcy courts and district courts throughout the nation” have “nearly uniformly” ruled “in line with our holding today.”
Will the IRS file a Petition for a Writ of Certiorari in the Zazzali v. U.S.A. case? Here’s hoping that it does. If so, it will be interesting to see whether the U.S. Supreme Court grants the Writ. Here’s hoping they do.