Bankruptcy – Trustee fails to recover debtor’s IRS tax penalty payments

Where the trustee sued the United States to void a debtor’s tax penalty obligations to the IRS, and to recover the debtor’s prior payments to the IRS, his claims were dismissed. A “noncompensatory tax penalty that is statutorily required and properly imposed” is not “within the ambit of the ‘exchanges’ targeted in the fraudulent-transfer laws.”

Background

The Bankruptcy Code and the related state fraudulent transfer laws permit a bankruptcy trustee to void a transaction and reclaim any property transferred where a debtor incurred an obligation or transferred property for less than “reasonably equivalent value” of the obligation or property. Here, the trustee sued the United States to void tax penalty obligations owed by the debtor to the IRS and to recover prior payments made by the debtor to the IRS upon such obligations. The district court affirmed the bankruptcy court’s dismissal of these claims.

Sovereign immunity

Under the government’s theory, an unsecured creditor could not void a transfer or obligation against the United States by applying the act—sovereign immunity would bar such a claim. Section 106(a) of the Bankruptcy Code, however, provides that “sovereign immunity is abrogated as to a governmental unit to the extent set forth in this section.” Subsection (a)(1) then lists several provisions under the Bankruptcy Code, including § 544, the avoidance statute invoked by the plan trustee, Richard P. Cook.

In addition, under subsection (b), once the government filed a proof of claim it has “waived sovereign immunity with respect to a claim against such governmental unit that is property of the estate and that arose out of the same transaction or occurrence out of which the claim of such governmental unit arose.” Here, the IRS indeed filed a proof of claim over Yahweh Center’s property.

Merits

The court now turns to the merits of Cook’s argument that Yahweh Center’s tax penalties and tax penalty payments should be voided. This circuit has yet to address this issue. But in In re Southeast Waffles, LLC, 702 F.3d 850 (6th Cir. 2012), the Sixth Circuit rejected the same arguments Cook advances here. There, the bankruptcy trustee sought to recover the debtor’s earlier payments on its tax penalty obligations and to avoid the unpaid tax penalty obligations under 11 U.S.C. § 548(a)(1)(B), which is the Bankruptcy Code’s fraudulent transfer provision, and the Tennessee Uniform Fraudulent Transfer Act, which resembles North Carolina’s statute.

Southeast Waffles held that tax penalty obligations were not avoidable under the Bankruptcy Code or the Tennessee fraudulent transfer statute. It noted that both statutes required an “exchange” for the obligation. The court agreed with the bankruptcy court’s conclusion that a “noncompensatory tax penalty that is statutorily required and properly imposed” was not “within the ambit of the ‘exchanges’ targeted in the fraudulent-transfer laws.” The Sixth Circuit reasoned that “noncompensatory penalties assessed and collected by the IRS do not fit neatly into the fraudulent transfer context.”

According to the Sixth Circuit, fraudulent transfer laws are designed to level the playing field among creditors, yet the IRS is “an involuntary creditor” and “tax penalties arise not through contractual bargaining but by operation of statute, and no value is or can be given in exchange.” The court finds this reasoning persuasive.

Applying the fraudulent transfer provisions to tax penalties would be cramming a square peg into a round hole. Since tax penalties are not obligations incurred as contemplated by the Act, it cannot be the “applicable law” required for Cook to bring this action under 11 U.S.C. § 544(b)(1). And if there is not applicable law for Cook’s § 544(b)(1) claim, the claim must be dismissed. Therefore, the district court’s dismissal of Cook’s challenge to the tax penalty obligations is affirmed.

The court also affirms the district court’s dismissal of Cook’s claim with respect to Yahweh Center’s previous payments of tax penalty obligations. The district court determined that such payments were not voidable because they resulted in a dollar-for-dollar reduction in the tax obligation debt and, thus, constitute “reasonably equivalent value.” This court agrees that the payment of a legitimate obligation reduces that obligation dollar for dollar and constitutes “reasonably equivalent value.”

Affirmed.

In re: Yahweh Center Inc. (Lawyers Weekly No. 001-049-22, 13 pp.) (A. Marvin Quattlebaum Jr., J.) Case No. 20-1685. March 8, 2022. From E.D.N.C. at Wilmington (Richard E. Myers II, C.J.) Richard Preston Cook for Appellant. Rachel Ida Wollitzer for Appellee. 4th Cir.