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Dividend Not a Fraudulent Transfer Due to Subchapter S Tax Benefits

Friday, December 21, 2012
Crumpton v. Stephens (In re Northlake Foods Inc.), M.D. Fla., No. 8:11-cv-02648-VMC, 9/27/12

  • Key Holding: Transfer of dividend to shareholder of bankrupt corporation not a fraudulent transfer or illegal dividend.

  • Key Takeaway: Debtor's Subchapter S tax benefits are reasonably equivalent value in exchange for the dividend transfer.


By Stephanie M. Acree

A dividend received by a shareholder of a bankrupt Subchapter S Georgia corporation was not a fraudulent transfer according to a Sept. 27 holding by the U.S. District Court for the Middle District of Florida (Crumpton v. Stephens (In re Northlake Foods Inc.), M.D. Fla., No. 8:11-cv-02648-VMC, 9/27/12).

Judge Virginia M. Hernandez Covington found that the debtor had received reasonably equivalent value for the dividend in the form of tax advantages. The court also found that Georgia law does not provide for a cause of action against shareholders who receive an illegal dividend.

 

Shareholders Agreement
Northlake Foods Inc. was a Subchapter S corporation in Georgia that owned approximately 150 Waffle House restaurants. Pursuant to its Subchapter S status, Northlake paid no income tax and instead, Northlake's shareholders would report pro rata shares of the company's income on their personal tax returns. However, pursuant to a shareholders agreement executed in 1991, Northlake was required to reimburse their shareholders for these taxes in the form of dividends.

In 2006, Richard Stephens, a Northlake shareholder, was issued a dividend in the amount of $94,429, which represented Stephens's share of Northlake's taxable income. Northlake's directors unanimously adopted a resolution authorizing the dividend.

 

Avoidance of Dividend
On Sept. 15, 2008, Northlake filed for Chapter 11 protection. In accordance with the order confirming the debtor's plan, David H. Crumpton was appointed as the distribution trustee for Northlake's distribution trust. On Sept. 16, 2010, Crumpton initiated an adversary proceeding against Stephens seeking to avoid and recover the 2006 dividend. Crumpton argued that the dividend was a fraudulent transfer pursuant to Sections 544(b)(1), 548, and 550 of the Bankruptcy Code and under the Georgia Uniform Fraudulent Transfers Act.

Stephens moved for a judgment on the pleadings and the bankruptcy court subsequently granted his motion and dismissed Crumpton's complaint without prejudice. Crumpton was given leave to file an amended complaint. On March 2, 2011, Crumpton filed his amended complaint alleging a cause of action for recovery of an illegal dividend under Georgia law. However, Stephens also moved to dismiss this complaint and the bankruptcy court again granted his motion.

Crumpton appealed both of the bankruptcy court's dismissals to the district court.

 

Reasonably Equivalent Value
The court first addressed the dismissal of Crumpton's fraudulent transfer claim. Pursuant to Section 548, a transfer made within two years before the bankruptcy filing can be avoided if the debtor received less than “reasonably equivalent value” and the debtor was insolvent or became insolvent as a result of the transfer. Neither party disputed that the transfer occurred within the two year window nor did they dispute the debtor's insolvency.

According to the bankruptcy court, the reasonably equivalent value the debtor received was the satisfaction of an antecedent debt, which is recognized as value by both the Bankruptcy Code and Georgia law. The bankruptcy court found that the dividend issued to Stephens was in satisfaction of the debt owed to him pursuant to the shareholders agreement. The bankruptcy court further found that the debtor had received reasonably equivalent value for the transfer “by virtue of the [d]ebtor's Subchapter S election for federal income tax purposes.”

 

'Not Worse Off'
The district court agreed with the bankruptcy court's conclusions. Crumpton argued that in evaluating the issue of value, the court should look to the perspective of the creditors, whom he claimed received no benefit from the transfer. However, the court said that in order for the transfer to not be fraudulent, the creditors need not necessarily benefit from the transfer as long as they were “not worse off” because of the transfer.

“Because the [d]ebtor would have had to pay incomes taxes itself had it not elected Subchapter S status, the [c]ourt cannot say that either it or its creditors were made worse off by the [d]ebtor's reimbursement to its shareholders for their portion of the income taxes paid,” the court said. Accordingly, the court upheld the dismissal of the fraudulent transfer claim based on the reasonably equivalent value received by virtue of the Subchapter S status. The court said it therefore need not address the bankruptcy court's additional finding that the transfer satisfied an antecedent debt.

 

Confusing the Issue
The court then addressed the dismissal of Crumpton's claim for recovery of illegal dividends. The bankruptcy court found that “Georgia law does not provide a cause of action against shareholders who receive an illegal dividend, but, rather, allows a party standing in the debtor's shoes to bring a cause of action only against the directors who assent to the distribution of an illegal dividend, who in turn may seek contribution from shareholders.”

The court said that in his appeal, Crumpton failed to “provide any statute or case law which would provide a basis for [him] to bring a claim directly against a shareholder to recover illegal dividends.” Instead, the court said Crumpton's argument “confusingly intertwine[d]” this issue with his fraudulent transfer claim in a way that not only failed to support the illegal dividend claim, but also “was not presented to or considered by the [b]ankruptcy [c]ourt, and thus, is not appropriate for consideration on appeal.”

Therefore, the court also upheld the dismissal of the amended complaint.

By Stephanie M. Acree

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