The Fourth Circuit Court of Appeals (the Court) recently ruled that a trustee may not avoid federal tax penalties as constructively fraudulent transfers under either § 548 of the Bankruptcy Code or under the North Carolina Uniform Voidable Transactions Act (UVTA) because the penalties are not “obligations” and do not arise from a voluntary exchange. Cook v. United States (In re Yahweh Center, Inc.), 2022 WL 677812 (4th Cir. 3/8/22).
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Debtor Yahweh Center is a non-profit corporation providing residential services to at-risk children. As early as 2003 it failed to pay certain tax obligations to both the IRS and the North Carolina tax authority. It filed a Chapter 11 in 2016, which caused the IRS to file a proof of claim for unpaid taxes, penalties, and interest, part of which was secured by tax liens.
After the Debtor confirmed a plan, Richard P Cook was appointed as plan trustee (Trustee). The Trustee sued the United States (the IRS) to avoid the tax penalties and to recover the tax penalty payments the Debtor had already made. He asserted such penalties and payments were constructively fraudulent transfers because the Debtor did not receive reasonably equivalent value in exchange for the penalties and payments.
The bankruptcy court granted the IRS’s motion to dismiss the complaint. It first rejected the government’s argument that sovereign immunity barred the lawsuit and then ruled on the merits that the Trustee’s theory of constructive fraud was inapplicable in the tax penalty context. The Trustee appealed to the district court, which affirmed. Its further appeal to the Court ended with a similar affirmance.
The Court first dispensed with the sovereign immunity assertion of the IRS, concluding that it did not shield the government for two reasons: (1) the IRS had submitted to the bankruptcy court’s jurisdiction by filing a proof of claim; and (2) § 106(a) of the Bankruptcy Code provides that “sovereign immunity is abrogated as to a governmental unit to the extent set forth in this section” and the section included § 544, under which the Trustee had sued, allowing the court “to determine any issue arising with respect to the application of such sections to governmental units.” The Court therefore ruled the bankruptcy court had jurisdiction to resolve the dispute.
Addressing the constructive fraudulent transfer claim, the Court, after noting it was an issue of first impression for the circuit, looked at the language in § 548 and the North Carolina UVTA to determine that both statutes, which are similar, are founded on the concept that a voluntary exchange has occurred between a debtor and a creditor. It concluded that the imposition of penalties for unpaid taxes by the IRS was not an exchange at all, with no value being given by either party to the “exchange.” To the contrary, the IRS was an “involuntary creditor “and was tasked by statute to impose the penalties.
The Court ruled that applying the fraudulent transfer provisions to tax penalties would be “cramming a square peg into a round hole.” It found the penalties are not “obligations” incurred as contemplated by the pertinent statutes. Not only were the penalties not fraudulent transfers, but the payments already made were similarly not recoverable.
This has to be the correct ruling and it is perhaps surprising it has not been addressed at the circuit level in the past. Perhaps because no other trustee had the audacity to assert the flawed legal theory. In the Ninth Circuit, our case law focuses on the “transfer” as the linchpin of a fraudulent transfer action. The imposition of penalties is not a transfer in the first place and could never be constructively fraudulent for that reason. When payments are made on the penalties, if that qualifies as a transfer, the debt owed will be simultaneously reduced dollar for dollar, creating reasonably equivalent value. A trustee in this circuit could not prevail on this theory either.
This review was authored by the Hon. Meredith Jury (U.S. Bankruptcy Judge, C.D. CA., Ret.), a member of the ad hoc group. Thomson Reuters holds the copyright to these materials and has permitted the Insolvency Law Committee to reprint them. This material may not be further transmitted without the consent of Thomson Reuters.