Taking sides on an issue that will likely reach the Supreme Court on a certiorari petition within the next year, the Fourth Circuit held that the Internal Revenue Service has no sovereign immunity protection to preclude an avoidance action under Section 544(b)(1).
Although it might seem obvious, Circuit Judge Marvin A. Quattlebaum, Jr. also held that tax penalties paid by a debtor are not avoidable as constructively fraudulent transfers.
The Sovereign Immunity Split
In 2017, the Ninth Circuit held in Zazzali v. U.S. (In re DBSI Inc.), 869 F.3d 1004 (9th Cir. Aug. 31, 2017), that the waiver of sovereign immunity under Section 106(a)(1) allows a trustee to file a derivative suit against the IRS for receipt of a state law fraudulent transfer under Section 544(b)(1). To read ABI’s report, click here.
The Ninth Circuit split with a Seventh Circuit opinion rendered three years earlier, In re Equipment Acquisition Resources Inc., 742 F.3d 743 (7th Cir. 2014). The Chicago-based appeals court reasoned that the waiver of immunity does not extend to Section 544(b)(1) suits because any actual creditor would have been barred from suing by the government’s sovereign immunity.
The Tenth Circuit is considering the issue now. In U.S. v. Miller, 20-00248, 2021 BL 340200 (D. Utah Sept. 8, 2021), the district court in Utah upheld Bankruptcy Judge R. Kimball Mosier by ruling that Section 106(a)(1) waives the federal government’s sovereign immunity with respect to underlying state law causes of action incorporated through Section 544(b). To read ABI’s report, click here.
The appellee’s brief in the Tenth Circuit is due this week. See U.S. v. Miller, 21-4135 (10th Cir.).
Tax Penalties Attacked
The corporate debtor had failed to pay state and local income taxes going back to 2003. The IRS assessed taxes, penalties and interest, some of which the debtor paid. The IRS also asserted liens.
In chapter 11, the IRS filed a claim for secured, unsecured priority and unsecured general claims.
After confirmation of a chapter 11 plan, the plan trustee sued the IRS under Section 544(b)(1) to avoid unpaid tax penalties, claiming that the payments were constructively fraudulent transfers under North Carolina’s version of the Uniform Voidable Transactions Act. Under the same theory, the plan trustee also sought to recover penalties that the debtor had paid.
The IRS raised sovereign immunity as a defense and also argued there was no fraudulent transfer on the merits.
The bankruptcy court found a waiver of sovereign immunity but dismissed the claims on the merits. The district court affirmed.
Sovereign Immunity Waived
On appeal to the circuit, the IRS contended there was sovereign immunity in bankruptcy court because sovereign immunity would have barred any actual creditor of the debtor from suing the IRS for a fraudulent transfer outside of bankruptcy court.
In his March 8 opinion, Judge Quattlebaum acknowledged the split but sided with the result reached in the Ninth Circuit. He said that the waiver of sovereign immunity in Section 106(a) “forecloses the government’s position that sovereign immunity bars any action by an unsecured creditor under” state law. Section 106(a)(1) includes Section 544 among the provisions in the Bankruptcy Code under which sovereign immunity “is abrogated as to a governmental unit.”
“In addition,” Judge Quattlebaum said, the filing of a claim by the IRS waived sovereign immunity under Section 106(b). That section says that a “governmental unit that has filed a proof of claim in the case is deemed to have waived sovereign immunity with respect to a claim against such governmental unit . . . .”
Because the IRS had filed a claim, Judge Quattlebaum said that “the government would have waived sovereign immunity if an unsecured creditor were to file a claim against it.”
No Claim on the Merits
The Fourth Circuit had not decided whether tax penalties could be fraudulent transfers, on the theory that the debtor received nothing in return. Judge Quattlebaum cited the Sixth Circuit for rejecting the same theory that the plan trustee had advanced. See In re Southeast Waffles, LLC, 702 F.3d 850 (6th Cir. 2012).
In Southeast Waffles, the Sixth Circuit said that Tennessee’s fraudulent transfer law required an “exchange,” but the IRS was an involuntary creditor. Tax penalties were imposed by operation of statute, with no value exchanged in the process.
Like Tennessee law, Judge Quattlebaum said that “North Carolina’s [Fraudulent Transactions] Act presumes a voluntary exchange between the debtor and the creditor” and “expressly” requires an “exchange.” The North Carolina fraudulent transfer law also requires “an oral or written agreement.”
“But none of that takes place with an IRS tax penalty obligation,” Judge Quattlebaum said. There was no written or oral agreement. “Since tax penalties are not obligations incurred as contemplated by the [state fraudulent transfer statute],” he said, the state law “cannot be the ‘applicable law’ required for [the plan trustee] to bring this action under 11 U.S.C. § 544(b)(1).”
There being no state law on which the plan trustee could base a Section 544(b)(1) claim, Judge Quattlebaum upheld dismissal of the claim to avoid unpaid tax penalty obligations.
Judge Quattlebaum also dismissed the claim to recover tax penalties that the debtor had paid, because there had been a dollar-for-dollar reduction in the debtor’s obligations.
Judge Quattlebaum added a proviso at the end of his opinion when he said that “our conclusion about the tax penalty payments turns on the legitimacy of the underlying tax penalty obligation.” In essence, he said that a payment might be recoverable if the underlying tax liability had been avoidable.
Taking sides on an issue that will likely reach the Supreme Court on a certiorari petition within the next year, the Fourth Circuit held that the Internal Revenue Service has no sovereign immunity protection to preclude an avoidance action under Section 544(b)(1).
Although it might seem obvious, Circuit Judge Marvin A. Quattlebaum, Jr. also held that tax penalties paid by a debtor are not avoidable as constructively fraudulent transfers.
In 2017, the Ninth Circuit held in Zazzali v. U.S. (In re DBSI Inc.), 869 F.3d 1004 (9th Cir. Aug. 31, 2017), that the waiver of sovereign immunity under Section 106(a)(1) allows a trustee to file a derivative suit against the IRS for receipt of a state law fraudulent transfer under Section 544(b)(1).