In re Gaither (Bankr. D. S.C.) – Trustee May Invoke Power of IRS to Avoid Debtors’ Disclaimer of Settlement Proceeds, Even Though Other Unsecured Creditors Could Not Do So Under State Law

The following is a case update prepared by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, analyzing a recent decision of interest:

SUMMARY:

A bankruptcy court in South Carolina has held that a trustee may invoke the power of the IRS to avoid the debtors’ disclaimer of settlement proceeds, even though other unsecured creditors could not have done so under applicable state law. [In re Gaither, 2018 Westlaw 6287971 (Bankr. D. S.C.).]

Facts: A family received a settlement of more than $1 million as a result of an aviation accident, in which one of the family’s sons was killed. The parents disclaimed their rights to the settlement proceeds; instead, the funds were distributed to the surviving children.

Three years later, the parents filed a Chapter 7 petition. The Internal Revenue Service claimed that the parents owed nearly $800,000. The Chapter 7 trustee filed an adversary proceeding against the surviving children, asserting that the parents’ disclaimer of the settlement proceeds could be recovered from the children under 11 U.S.C.A. §544(b). The trustee’s complaint alleged that she had the power to step into the shoes of the IRS and could therefore invoke the Federal Debt Collection Procedures Act (“FDCPA”) to avoid the disclaimer as a fraudulent transfer.

The defendants moved to dismiss the complaint for lack of standing, arguing that the trustee’s powers under §544(b) did not enable her to step into the shoes of the IRS.

Reasoning: The court first observed that under South Carolina law, the disclaimer of the settlement proceeds meant that the parents never received the money in the first place. However, under federal tax law, the result was the opposite, empowering the IRS to avoid the disclaimer of the proceeds.

The court then held that the IRS could serve as the triggering creditor for purposes of §544(b), since the IRS was the holder of an actual unsecured claim. The court noted a split of authority but reasoned that the weight of the case law was in favor of the trustee’s power to step into the shoes of the IRS. The court also held that the FDCPA constituted the “applicable law” for purposes of §544(b).

Author’s Comment: This is yet another manifestation of the emerging “shoes of the taxman” theory. Here, the IRS had the power to override state law regarding disclaimers of settlement proceeds. The trustee got to invoke that magic power, even though none of the estate’s other creditors could have done so. That sounds a little unfair, but that is the rule of Moore vs. Bay, 284 U.S. 4, 52 S.Ct. 3, 76 L.Ed. 133 (1931): a transfer void as to one creditor is void as to all.

The ability of bankruptcy trustees to use the IRS in order to leverage the estate’s avoidance powers is very significant: since most bankrupt debtors have tax problems, many fraudulent transfer recipients will face an expanded risk of liability. Although we do not yet have much circuit-level guidance, I predict that this theory will be widely adopted and widely upheld.

For discussions of cases dealing with related issues, see:

• 2017-21 Comm. Fin. News. NL 41, Trustee May Assert Fraudulent Transfer Claims Derived From Avoidance Powers Belonging to IRS, Free of State Law Statute of Limitations.
• 2016-40 Comm. Fin. News. NL 80, Bankruptcy Trustee May Borrow IRS 10-Year Statute of Limitations in Fraudulent Transfer Litigation.

These materials were written by Dan Schechter, Professor Emeritus, Loyola Law School, Los Angeles, for his Commercial Finance Newsletter, published weekly on Westlaw. Westlaw holds the copyright on these materials and has permitted the Insolvency Law Committee to reprint them.