Supreme Court Case Pits Bankruptcy Trustee Power Against IRS

The US Supreme Court’s decision to hear a bankruptcy case involving the IRS opens the door for bankruptcy trustees to claw back more potentially fraudulent payments made to government entities.

The dispute sets up a showdown between bankruptcy law and state law. A ruling in favor of trustees would likely result in additional money available to pay back junior, nongovernment creditors—a group that typically sees little recovery on the debts they’re owed in a bankruptcy.

Trustees are often appointed in bankruptcies to undo fraudulent pre-bankruptcy payments—with approval from a bankruptcy judge—and use that money to pay back junior creditors.

“When you claw back money from the government, it benefits all of the creditors,” said Edward Morrison, a professor at Columbia Law School.

The justices on June 24 agreed to consider an appeal from the Tenth Circuit over whether a bankruptcy court can turn to Utah’s fraudulent transfer law to extend the statute of limitations for the trustee’s ability to recover a payment from a company, before its bankruptcy, to the IRS.

The high court’s decision will have a narrow, but notable, ripple effect on other bankruptcy cases involving payments to government entities. The US Bankruptcy Code allows a trustee to claw back a property transfer, or payment, made in the two years leading up to a bankruptcy filing if it would be found fraudulent in another court.

The Supreme Court’s ruling could extend that time period by two years, depending on the limit allowed by state law—potentially opening up more payments that could be unwound and used to pay back other creditors.

Legal professionals and academics say the most common suits filed by bankruptcy trustees against the government aim to recover alleged fraudulent transfers to the IRS made while a company was insolvent.

However, the government has contended that it has sovereign immunity against suits seeking recovery of transfers beyond the two-year lookback period permitted under the bankruptcy code.

“If the Supreme Court were to rule that the government gets sovereign immunity, that would mean that the IRS, in particular, would have special treatment relative to all other creditors,” Morrison said.

Federal appeals courts are split 3-1 over whether a bankruptcy trustee should be permitted, under state law, to claw back funds paid to the government beyond the two-year standard under the bankruptcy code. The Fourth, Ninth and Tenth circuits have allowed bankruptcy trustees to claw back payments, while the Seventh Circuit hasn’t.

State Law v. Bankruptcy Law

The government has argued that the US Court of Appeals for the Tenth Circuit was wrong when it affirmed a Utah bankruptcy court ruling allowing a liquidating trustee to sue the IRS to claw back tax payments.

The government’s argument is focused on a bankruptcy law statute that mandates what types of pre-bankruptcy payments can be recovered to pay creditors, said Susan Block-Lieb, a professor at Fordham University School of Law.

“What the government is arguing is, under 544(b) you have to show an actual creditor that could’ve brought that suit outside of bankruptcy, and you can’t find that because of the doctrine of sovereign immunity,” Block-Lieb said.

Section 544 of the bankruptcy code “allows the trustee to piggyback off of state fraudulent transfer law,” said Alexander Gouzoules, a professor at the University of Missouri School of Law.

The big question that will be decided by the high court is “did Congress waive sovereign immunity in this specific context,” Gouzoules said.

The US Bankruptcy Court for the District of Utah decision found in 2020 that a bankruptcy trustee for transportation company All Resort Group Inc. could recover a $145,000 payment to the IRS for “personal tax debts” on behalf of two former directors. The bankruptcy was filed in 2017, three years after the payment was made to the IRS.

Although the bankruptcy code only has the two-year lookback period, Utah law allows the clawback of such transfers that occurred up to four years before a bankruptcy, according to court papers.

“If the Supreme Court reverses the decision from the Tenth Circuit, and finds for the government, that would mean trustees could no longer pursue causes of action to claw back if it’s beyond the two-year window,” said Joseph Orbach, a partner at Thompson Coburn LLP.

Suits seeking to claw back funds within the two years protected by the bankruptcy code will remain unaffected because there is a clear sovereign immunity waiver in place, Orbach said.

Another section of the code allows a bankruptcy trustee to use any applicable law to recover fraudulent transfers on behalf of creditors.

That law is typically a state’s uniform fraudulent transfer act, which has a four-year lookback period in 46 states and Washington, D.C., according to the liquidating trustee’s May brief.

Because a successful clawback requires only one creditor to be qualified to sue for recovery of fraudulent transfers, all creditors are incentivized to do so in case a bankruptcy trustee is appointed, said Morrison of Columbia Law School.

“These suits can be very attractive,” he said. “Because even if there might be 100 creditors, and only one has a right to sue the government, that one creditor’s right to sue the government is shared with all the other creditors.”

The case is United States v. Miller, U.S., No. 23-824, certiorari granted 6/24/24.