The U.S. Supreme Court ruled on March 26 that state and federal law do not allow a bankruptcy trustee to take back a payment made to the IRS that may have been fraudulent.
A bankruptcy trustee is appointed by a court to administer a debtor’s estate in a bankruptcy proceeding. The trustee monitors the debtor’s financial condition, collects assets, and distributes money to creditors.
A creditor normally has to rebate to the trustee payments the debtor made in the run-up to the bankruptcy filing. When a debtor makes a payment in an effort to avoid paying creditors, a court can declare the transaction a fraudulent transfer.
In this case, the justices were asked to consider whether payments have to be rebated when the IRS is the recipient.
Such a filing allows debtors to reorganize their affairs and remain in business.
In 2014, when the company was already insolvent, it took the unusual step of paying $145,138 to the IRS to satisfy the individual tax debts of two of the company’s principals.
A federal bankruptcy court in Utah converted the Chapter 11 case into a Chapter 7 proceeding, in which a trustee sells off the debtor’s assets to cover debts. The debtor is allowed to keep certain property that the law exempts from liquidation.
The bankruptcy trustee, David Miller, initiated what is called an adversary proceeding against the United States within the bankruptcy case in an effort to void the payments that were made to the IRS.
Section 544(b) of the U.S. Bankruptcy Code permits a trustee to challenge “any transfer … that is voidable under applicable law by a creditor” who has a valid claim.
Miller argued that the bankruptcy estate was entitled to recoup the payments to the IRS even though the tax agency, as a part of the federal government, enjoys sovereign immunity. Sovereign immunity is a legal doctrine that prevents governments from being sued in their own courts unless they agree they may be sued.
The bankruptcy court determined that because the tax payments were made more than two years before the company’s bankruptcy petition was filed, the trustee’s claim under the Bankruptcy Code’s fraudulent transfer clause was filed too late.
However, the bankruptcy court agreed with the trustee that under Utah law, the IRS payment could be voided because that state’s law allows four years to revoke a payment that was fraudulent.
The bankruptcy court awarded the trustee a judgment against the United States for $145,138 in March 2020. The federal government appealed, and the federal district court in Utah upheld the ruling in September 2021.
The federal government appealed again, and the U.S. Court of Appeals for the 10th Circuit affirmed in June 2023.
Yet the government argued that the IRS should retain assets that others would be required to give back, Blatt said.
“That result would prevent the trustee from recouping this money and paying it to the bus drivers and the mechanics and the vendors who certainly gave All Resort more value than the IRS did,” the lawyer said.
The Supreme Court held in its new ruling that the IRS’s sovereign immunity prevails over both the Bankruptcy Code and state law provisions allowing a trustee to claw back fraudulent transfers.
In the majority opinion, Jackson recounted the facts of the case, writing that the Bankruptcy Code allows a bankruptcy trustee to “avoid” some transfers of a debtor’s assets and take them back to benefit the bankruptcy estate.
Section 544(b) permits a trustee to use those avoidance powers regarding transfers that can be voided outside bankruptcy proceedings.
“Trustees typically rely on state statutes to supply the ‘applicable law’ when suing under [Section] 544(b) to avoid a debtor’s transfer of assets,” she wrote.
Usually, the federal government’s sovereign immunity would prevent it from being sued under Utah law, but Section 106(a) of the Bankruptcy Code waives immunity “with respect to” Section 544(b), thereby allowing lawsuits against the government to proceed, Jackson wrote.
The justice wrote that the Supreme Court was called upon to decide whether another federal statute, Section 106(a), “abrogates sovereign immunity only with respect to the federal cause of action created by [Section] 544(b) or whether it also abrogates sovereign immunity with respect to the underlying state law claims that supply the ‘applicable law’ for that federal cause of action.”
Abrogation is the act of formally annulling a law or legal provision. A cause of action is a set of facts that provides a legal basis for suing someone.
The Supreme Court determined that although Section 106(a) has the effect of abrogating sovereign immunity for the Section 544(b) cause of action, “it does not take the additional step of abrogating sovereign immunity for whatever state-law claim supplies the ‘applicable law’ for a trustee’s [Section] 544(b) claim.”
“Construing [Section] 106(a) to modify the elements of a [Section] 544(b) claim would … reflect a highly unusual understanding of sovereign-immunity waivers,” Jackson wrote.
The Supreme Court reversed the ruling of the Tenth Circuit.
