No Time Runs against the King (IRS): The Golden Creditor Rule and its Discontents | Weil, Gotshal & Manges LLP
[co-authors: Emma Wheeler, and Alex Xiao]
A North Carolina bankruptcy court recently joined a growing number of courts allowing debtors and trustees to avoid pre-transactions by using the IRS’s ten-year retrospective period, rather than the applicable statute of limitations. ‘State.1 In In Zagaroli, the West District of North Carolina Bankruptcy Court ruled that a trustee could step into the shoes of the IRS in an attempt to avoid a Section 544 (b) transfer, thus using the longer return period available to the IRS. No. 18-50508, 2020 Bankr. LEXIS 3111 (Bankr. WDNC, November 3, 2020). In this article, we discuss not only the Zagaroli case, but also the relevant arguments surrounding the split between the courts on this issue.
The debtor, Peter Lawrence Zagaroli, filed for Chapter 7 bankruptcy in May 2018. About seven years earlier, the debtor reportedly transferred several real estate assets to his parents for no consideration. The trustee sought to avoid these transfers, which took place while Mr. Zagaroli was insolvent, under section 544 (b) of the Bankruptcy Code.
Section 544 (b), also known as the Creditor’s Golden Rule, allows a trustee to step into the shoes of any unsecured creditor to avoid any transfer that the creditor might avoid under the ” applicable law “. Most states have adopted a Uniform Voidable Transactions Act that provides for a statute of limitations to avoid transfers. Under applicable law in North Carolina, the statute of limitations is four years.
In this case, the trustee sought to use the IRS, which held an unsecured debt, as its preferred creditor in an attempt to invoke the Internal Revenue Code as applicable law. The Internal Revenue Code, under Section 26 USC § 6502, provides a ten-year period for collecting a tax.
The court, using a plain language reading of 544 (b), ruled that the trustee could step into the shoes of the IRS to avoid transfers under the Internal Revenue Code. The court agreed with the majority view that “applicable law” should be interpreted broadly to include the Internal Revenue Code, which the IRS could have used to recover outside of bankruptcy.
In so ruling, the court rejected the assignees’ arguments that 544 (b) “does not give the trustee the power to bring actions based on allegations of tax evasion which are only available in the United States. outside of the bankruptcy arena and that a trustee should not be able to invoke US immunity from state limitation periods. The court found these arguments unconvincing, noting that the assignees’ position would leave both the trustee and the IRS without recourse to avoid transfers that they would otherwise be entitled to avoid outside of bankruptcy.
Wider Context: IRS as Gold Creditor
Holding In Zagaroli This is hardly surprising since the majority of bankruptcy court decisions on this issue have reached the same conclusion. However, since no circuit court has yet addressed the issue, further discussion is warranted on whether the debtor or trustee can use the IRS as a preferred creditor and what arguments the parties have made. in court so far.
The common law tradition has historically granted a longer limitation period to sovereign actors than to private actors. An ancient doctrine known as nullum tempus occurrit regi, or “no time runs against the king”, was recognized by the Supreme Court of the United States in United States v. Summerlin, where the Court ruled that “the United States is not bound by state limitation periods or subject to the defense of breaches in the exercise of its rights.” 310 US 414, 416 (1940). The modern rationale for this rule, as enunciated by the Ninth Circuit, is that “public rights, income and property should not be confiscated due to the negligence of public officials”. SEC vs. Rind, 991 F.2d 1486, 1491 (9th Cir. 1993). This historic principle is the foundation that allows the Internal Revenue Service to pre-empt the statute of limitations from state law and be bound only by the statute of limitations of the Internal Revenue Code.
The question then, in context 544 (b), is whether the trustee can use the IRS’s preemptive power to obtain a longer payback period. In the absence of a circuit-level decision, the most notable bankruptcy court decision disapproving of the IRS as a preferred creditor is About Vaughan. 498 BR 297 (Bankr. DNM 2013). the Vaughan The court dismissed a trustee’s request to avoid an alleged fraudulent transfer that occurred beyond the state’s 5-year statute of limitations, but under that of the IRS, a creditor unsecured in the case.
the Vaughan the court’s decision was based on two arguments. First the nullum tempus the doctrine does not apply because the trustee in bankruptcy is not sovereign and his actions do not protect the public interest. Second, because the IRS holds unsecured debts in “a substantial portion of bankruptcy cases”, allowing the trustee to step into the IRS’s shoes would virtually render state limitation periods moot. Identifier. to 305. The Vaughan court concluded that Congress could not have foreseen this political consequence.
A number of courts have since considered and rejected both of these arguments. See for example., In re Gaither, 595 BR 201 (Bankr. DSC 2018), In re Kipnis, 555 BR 877 (Bankr. SD Fla. 2016), and Hillen v. City of many trees (Regarding CVAH, Inc), 570 BR 816 (Bankr. D. Idaho 2017). the Kaiser court, for example, rejected the Vaughan law courts nullum tempus analysis noting that 544 (b) has always granted a derivative right to the trustee. Ebner v. Kaiser (In re Kaiser), 525 BR 697, 713 (Bankr. ND Ill. 2014). For these courts, first, it does not matter whether the trustee is sovereign, as the trustees exercise rights only on behalf of the IRS, which can legitimately prevail over state law in accordance with the Internal Revenue Code. Likewise, a majority of courts have rejected the Vaughan the court’s second political argument granting the IRS preferred creditor status citing the plain and unambiguous language of 544 (b), as in Zagaroli.
Another argument against using the IRS as a preferred creditor is that this practice could potentially lead to an unlimited payback period. See In re CVAH, Inc., 570 BR to 838. The 10-year limitation period on the IRS does not begin to run until after the taxpayer files a tax return. Since the taxpayer could theoretically delay filing the tax return for an unlimited period of time, the IRS and the trustee could avoid transactions for an unlimited return period.
The courts have also dismissed this concern. the CVAH the court noted that meeting deadlines is only one element of a request for a fraudulent transfer by interpretation. Identifier. at 838. In practice, the burden of proving the claim would probably become more onerous for the trustee the further back the transfer occurs from the date of the bankruptcy application.
Take away food
While no circuit court has addressed the gold creditor rule with respect to the IRS, the Western District of North Carolina Bankruptcy Court joins a growing number of bankruptcy courts in declaring that the “applicable law” under 544 (b) includes the Internal Revenue Code and its 10 Year Limitation Period.
It should also be noted that when recovering transactions in place of the IRS, the trustee or debtor may recover more than the amount that was owed to the IRS. At least one court has ruled that the trustee could use the IRS as a preferred creditor even when the IRS claims were paid in full after the bankruptcy case began. See In re Grand Se. Cmty. Hospital. Corp. I, 365 BR at 301. Therefore, in cases where the IRS holds an unsecured debt, the application by the majority courts of the gold creditor rule significantly increases the limitation period that a debtor or assignee must analyze to recover transactions in the bankruptcy estate. Parties that transact with distressed businesses or businesses that become distressed will be exposed to a much larger window of potentially avoidable transactions. Because the IRS is so often a creditor in bankruptcy cases, decisions allowing a debtor or trustee to use the IRS as a preferred creditor threaten to significantly expand the universe of avoidable transactions. It remains to be seen, however, whether a circuit court will take up this issue or contradict the majority rule in bankruptcy courts.
1 See, for example, Vieira v. Gaither (In re Gaither), 595 BR 201 (Bankr. DSC 2018); Mukamal v. Citibank (In re Kipnis), 555 BR 877 (Bankr. SD Fla. 2016); Ebner v. Kaiser (In re Kaiser), 525 BR 697 (Bankr. ND Ill. 2014); Alberts v. HCA Inc. (In re Greater Se. Cmty. Hosp. Corp. I), 365 BR 293 (Bankr. DDC 2006); Shearer v. Tepsic (In re Emergency Monitoring Technologies, Inc.), 347 BR 17 (Bankr. WD Pa. 2006); Osherow v. Porras (In re Porras), 312 BR 81 (Bankr. WD Tex. 2004).