Tim’s Tax News on the Tenth – September 2017

COURT ALLOWS DERIVATIVE SUIT AGAINST THE INTERNAL REVENUE SERVICE

In a recent Ninth Circuit case, Zazzali v. U.S. (In re DBSI Inc.), 16-35597 and 16-35598 (9th Cir. Aug. 31, 2017), the Court created a split with the Seventh Circuit (that includes Illinois), by holding that the waiver of sovereign immunity under §106(a)(1) enables a bankruptcy trustee to file a derivative suit against the IRS for receipt of a fraudulent transfer under §544(b)(1).

DBSI, Inc. and its affiliated entities engaged in the acquisition, development, management, and sale of commercial real estate properties throughout the United States. They did so, however, through an illegal Ponzi scheme—during their last two years in operation they purportedly lost $3 million per month and used new investor funds to meet existing obligations. During the four year period prior to filing for bankruptcy DBSI paid the IRS about $17 million on account of taxes owing by its shareholders. Under a confirmed chapter 11 plan, the trustee for a creditors’ trust sued the IRS to recover the payments.

To recover the $17 million, the bankruptcy trustee sued under Idaho’s Uniform Fraudulent Transfer Act, invoking §544(b)(1), which requires the existence of an actual, unsecured creditor who could have sued under the state law. The government filed a motion for summary judgment on the §544(b)(1) claim, because any creditor would have been barred by sovereign immunity from suing the government for receipt of a fraudulent transfer. The district court granted the trustee’s cross motion for summary judgment, holding that §106(a)(1) waived sovereign immunity for derivative fraudulent transfer claims brought under §544(b)(1).

The Ninth Circuit upheld the district court in an August. 31 2017 and thereby creating a split of circuits with the Seventh Circuit’s In re Equipment Acquisition Resources Inc., 742 F.3d 743 (7th Cir. 2014) (“EAR”). The EAR Court held 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 Ninth Circuit’s opinion stated it could find no other circuit decisions on this question.

The Ninth Circuit’s held reading the two sections together that the abrogation of sovereign immunity is “absolute” and “thus necessarily includes the derivative state law claim on which a Section 544(b)(1) claim is based.” The Court further commented in terms of logic, that the government’s argument “would essentially nullify Section 106(a)(1)’s effect on Section 544(b)(1), an interpretation we should avoid.” The Court additionally, stated, “It would defy logic to waive sovereign immunity as to a claim which could not be brought against the government.” The Ninth Circuit also rested its decision on equity stating the Bankruptcy Code was drafted to put the IRS “on an equal footing with all other creditors.” And “it would be unfair for the governmental unit to participate in the distributions in a bankruptcy case while at the same time shielding itself from liability,” quoting the Tenth Circuit from In re Franklin Savings Corp., 385 F.3d 1279, 1290 (10th Cir. 2004).

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