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Court Holds Penalty Payments Made to the IRS Do Not Constitute Fraudulent Transfers

Friday, December 16, 2011

Adrienne Woods | Bloomberg LawIn re Southeast Waffles, LLC, No. 11-8012, 2011 BL 302256 (B.A.P. 6th Cir. Nov. 30, 2011) The United States Bankruptcy Appellate Panel for the Sixth Circuit (the "BAP") affirmed the bankruptcy court's ruling dismissing a complaint seeking to avoid non-compensatory penalty payments made to the Internal Revenue Service (the "IRS") as fraudulent transfers pursuant to Federal Rule of Civil Procedure12(b)(6) for failure to state a claim upon which relief could be granted. In so ruling, the BAP rejected the debtor's contention that it did not receive reasonably equivalent value in exchange for the transfers.

Debtor's Penalty Payments and the Fraudulent Transfer Complaint

Southeast Waffles, LLC ("Debtor") owned and operated approximately 113 Waffle House restaurants. Between 2005 and 2008, Debtor failed to make certain federal income tax, social security and unemployment payments, and to timely file income tax returns relating thereto, as a result of which the IRS assessed penalties in excess of $1.5 million. Debtor made payments to the IRS totaling $637,000 (the "Penalty Payment") during this period, all of which the IRS applied to penalties as opposed to actual tax and interest due. In 2008, Debtor filed a petition under chapter 11 of the Bankruptcy Code. Debtor's First Amended Plan of Reorganization was confirmed, and subsequently Debtor filed an adversary complaint (the "Complaint") seeking avoidance and recovery of the Penalty Payment under constructive fraudulent conveyance theories pursuant to both the Bankruptcy Code and Tennessee Uniform Fraudulent Transfer Act (TUFTA). 11 U.S.C. §§ 548(a)(1)(B) and 550(a)(1); Tenn. Code §§ 66-3-301 et seq. Debtor alleged in its complaint, inter alia, that: (i) the Penalty Payment provided no value to Debtor as it did not reduce the amount owed in actual taxes and interest; and (ii) Debtor did not receive reasonably equivalent value in exchange for the Penalty Payment. The IRS filed a motion to dismiss the Complaint for failure to state a claim upon which relief may be granted pursuant to Rule 12(b)(6), alleging that Debtor did, in fact, receive reasonably equivalent value in the form of a dollar-for-dollar reduction in the liability the Debtor owed to the IRS. Debtor moved for summary judgment. While the IRS opposed the legal arguments made by Debtor in the motion for summary judgment, it disputed none of the facts set forth in the Complaint. After a hearing on the motion to dismiss and the summary judgment motion, the bankruptcy court granted the motion to dismiss. Noting that it was undisputed that the penalty payment constituted a legitimate debt owed by Debtor to the IRS, the bankruptcy court held that the dollar-for-dollar reduction of the penalty payments due constituted reasonably equivalent value in exchange for the Penalty Payment. Debtor appealed the ruling to the BAP.

The Penalty Payment Provided Equivalent Value to Debtor

On appeal, Debtor disputed that it received reasonably equivalent value for the Penalty Payment on the basis that the IRS applied the Penalty Payment to the penalty portion of the liability rather than to tax and interest, and, as such, the payment was not for an actual pecuniary loss. Debtor also alleged that because the payment, as applied, did not reduce either the tax or interest due, Debtor received no value in exchange for the Penalty Payment. Reviewing the matter de novo, the BAP noted that, pursuant to the Bankruptcy Code, a trustee may avoid any transfer of an interest of the debtor that was made or incurred on or within two years before the date upon which the bankruptcy petition is filed if, among other things, the debtor receives less than reasonably equivalent value in exchange for the transfer. Further, the BAP recognized that TUFTA also requires the debtor to show it failed receive reasonably equivalent value for transfers in order to recover them under a theory of constructive fraud. The BAP explained that both the Bankruptcy Code and TUFTA define "value" to include the satisfaction of an antecedent debt but neither define "reasonably equivalent value", which is generally understood to be a question of fact. Noting that the penalty Debtor owed was part of the tax liability, the BAP held that Debtor did receive reasonably equivalent value for the Penalty Payment because the payment reduced Debtor's overall liability to the IRS. The BAP added that, pursuant to the Internal Revenue Code, "any reference in this title to 'tax' imposed by this title shall be deemed also to refer to the penalties and liabilities . . . ." 26 U.S.C. § 6671(a). Accordingly, the IRS does not distinguish between the tax and penalty portions of the liability, and payment of any portion of the liability constitutes a dollar-for-dollar reduction of the tax liability resulting in the debtor's receipt of reasonably equivalent value. Thus, while the BAP agreed with Debtor that the tax penalty was not compensation for an actual pecuniary loss, it found no basis to support Debtor's argument that non-compensatory penalties constitute fraudulent conveyances.

The Bankruptcy Appellate Panel Affirms the Bankruptcy Court's Holding

In sum, the BAP affirmed the bankruptcy court dismissal of the Complaint, ruling that Debtor received equivalent value in exchange for the Penalty Payment - not simply reasonably equivalent value, but actual equivalent value - as it reduced, dollar-for-dollar, the amount of Debtor's antecedent debt to the IRS. DisclaimerThis document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. The Bureau of National Affairs, Inc. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.©2014 The Bureau of National Affairs, Inc. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of The Bureau of National Affairs, Inc.

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