On June 28, 2019, the U.S. Supreme Court granted certiorari in the case of Rodriguez v. FDIC, (Supreme Court Case No. 18-1269). The case is about a $4 million tax refund received by a parent corporation in bankruptcy, based upon losses from one of its wholly owned subsidiaries. The question is this: Who get’s the refund money?
Circuit courts of appeals are widely split on how the tax refund should be handled.
[Editorial Note: You’d think the source of the refund money (i.e., who paid the money to the IRS?) would be an important consideration, right?]
A Simplified Description
Here’s the essence of what the case is about.
- Parent corporation has three wholly-owned subsidiaries;
- One tax year, each of the four corporations pays estimated taxes of $1 million to the IRS, for a total of $4 million;
- Parent and two of its subsidiaries have a tax wash for that tax year so that, under a separately filed tax return, each would owe no taxes and would be entitled to a full refund of its $1 million payment;
- The other subsidiary has a huge tax loss that year and would also be entitled to a full refund of its $1 million payment under a separately filed tax return;
- But the parent, instead, files a consolidated tax return for itself and its three subsidiaries that year and is entitled to receive a $4 million refund from the IRS for all four entities under the consolidated return;
- Parent files bankruptcy and then receives the $4 million tax refund; and
- All four corporations are insolvent—they have common creditors because of guarantees, but each also has substantial creditors of its own.
So the questions, in the hypothetical, are these two: Which corporation(s) is/are entitled to the $4 million tax refund money? And why?
The foregoing is the essence of the legal dispute before the U.S. Supreme Court in Rodriguez v. FDIC.
–An Obvious Answer?
Before looking at the legal history behind the hypothetical and its questions, what do you think the result should be? How about this:
- Each corporation should get back the $1 million it paid.
Doesn’t that seem obvious?
Why, after all, should the creditors of an insolvent corporation be deprived of its debtor’s asset without a fair consideration in return? Wouldn’t a contrary result be, in effect, a fraudulent transfer?
The Current Legal Framework
While legal standards and their application vary widely on the questions at issue, the general structure goes something like this.
When a parent corporation and its wholly owned subsidiaries file a consolidated tax return, they do so in the name of the parent corporation. All dealings with the IRS concerning the tax return are through the parent corporation, and the combined refunds are paid by the IRS to the parent corporation alone. All of this is required by IRS rules and regulations.
So, in the hypothetical above, the $4 million refund for all four corporations is paid to the parent corporation—a bankruptcy debtor. That’s how the questions arise.
–An Initial Presumption
A presumption established many years ago by the Ninth Circuit Court of Appeals is this: The refund money should go to “the company responsible for the losses that form the basis of the refund” (In re Bob Richards Chrysler-Plymouth Corp., Inc., 473 F.2d 262, 265 (9th Cir. 1973)).
This presumption makes sense when, (i) the tax liability for three of the four affiliates, under a separately filed return, would be greater than what they paid in, and (ii) the only reason they are getting a refund is because of the consolidated return and the forth affiliate’s huge losses. But what about other circumstances?
The fundamental problem with the initial presumption, as a general legal standard, is that it ignores this question:
- Who paid the money to the IRS that is the source of the refund?
–A Contract Exception to the Presumption
The Ninth Circuit’s initial presumption can be overcome by an agreement between the parent corporation and its wholly owned subsidiaries. So, hypothetically, if an inter-affiliates agreement provides that one of the three subsidiaries (e.g., the one that has lots of insider creditors) gets the refund, then that contract controls.
Seriously?! We’re going to let a bunch of insiders agree on how to divide a major asset between their insolvent and affiliated entities? Doesn’t that invite manipulation and fraudulent action?
–An Ambiguity Exception to the Contract Exception to the Presumption
An agreement between the parent and its wholly owned subsidiaries on dividing the refund will control, unless it is ambiguous on the division question.
The litigation history of the Rodriguez v. FDIC case is a perfect example of how the ambiguity standard creates uncertainty and confusion:
No ambiguity: The Bankruptcy Court found that the parent and its wholly owned subsidiaries had an unambiguous agreement on division of the refund. Under the agreement, according to State law, the subsidiaries held a creditor claim against the parent for the refund money, not an agency or trust claim. Therefore, the Bankruptcy Court concluded, (i) the initial presumption does not apply, (ii) the parent corporation in bankruptcy owns the entire refund, (iii) the wholly owned subsidiaries are nothing more than general unsecured creditors of the parent for their shares of the tax refund money, and (iv) the parent in bankruptcy is entitled to keep the entire refund for distribution to its creditors, including the three subsidiaries for their respective shares of the tax refund money.
Ambiguity: The U.S. District Court reversed on appeal. It applied State law, finding the agreement between the affiliated entities to be ambiguous on whether, (i) the subsidiaries are merely creditors of the parent, or (ii) the parent holds the refund money as their agent. It then awarded the refund to the subsidiary that had the large losses, based on a provision in the agreement that any ambiguity should be resolved in favor of that subsidiary.
Ambiguity: The Tenth Circuit Court of Appeals affirmed the District Court’s reversal and analysis.
All of this is interesting. And, no doubt, it makes perfectly good sense in the context before the Rodriguez v. FDIC courts.
–No Reference to the Source of the Refund
But nowhere does any of those three Rodriguez v. FDIC opinions clearly specify where the refund money came from. Nor does the Petition for a Writ of Certiorari.
It’s possible that the subsidiary entitled to the money under the District and Circuit Court opinions was the one who actually paid the $4 million to the IRS that became the refund. But they don’t say that for sure. It’s probably assumed.
But shouldn’t the legal standard for such questions include at least a tip of the hat to the actual source(s) of the refund money?
Here’s hoping the U.S. Supreme Court will bring clarity and simplification to this tax refund division issue. And here’s hoping they will include a requirement that the refund money source(s) be identified and considered.
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