It is no secret that the IRS and other taxing authorities do well in bankruptcy, often at the frustration of both debtors and creditors. For debtors, tax claims frequently are nondischargeable. For general unsecured creditors, IRS claims are entitled to higher priority. However, a recent decision from the Ninth Circuit Court of Appeals, In re DBSI Inc., offers new precedent that swings the balance back toward debtors and general unsecured creditors at the expense of the IRS.
The DBSI court held that a trustee may, using a state’s enactment of the Uniform Fraudulent Transfer Act (UFTA), avoid a debtor’s pre-petition tax payment made to the IRS under § 544(b)(1), notwithstanding the doctrine of sovereign immunity. In so doing, the DBSI court declined to follow In re Equip. Acquisitions Res. Inc., a 2014 Seventh Circuit decision holding to the opposite effect, thereby creating a split between these two circuits. For plaintiffs in the Ninth Circuit prosecuting avoidance actions, the DBSI decision could provide a new, viable avenue for recovery.
The § 544(b)(1) Avoidance Power
Section 544(b) enables a trustee or debtor in possession to avoid any transfer “under applicable law by a creditor holding an unsecured claim.” As a practical matter, § 544 allows bankruptcy trustees to avoid transfers made beyond the two-year limitations period of § 548 by incorporating the often-longer limitations periods provided under state fraudulent transfer law.
In contrast to the broad avoidance powers of § 544(a), which provides a trustee with the powers of a hypothetical lien creditor or a bona fide purchaser, one limitation to § 544(b) is the requirement that there must exist an actual unsecured creditor who could have brought the avoidance action in the first instance. As the EAR court stated, “[T]he trustee stands in the shoes of an actual unsecured creditor. And if the actual creditor could not succeed for any reason — whether due to the statute of limitations, estoppel, or res judicata, waiver, or other defenses — then the trustee is similarly barred and cannot avoid the transfer.”
Section 106 and the Doctrine of Sovereign Immunity
The doctrine of sovereign immunity protects federal and state governments from suit by citizens. The government may be amenable to suit, however, if it consents to the suit, waives its sovereign immunity, or if sovereign immunity is specifically abrogated under a statute. In the Bankruptcy Code, § 106 lists every Bankruptcy Code provision where sovereign immunity is expressly abrogated and thus the government may be sued. Section 544 is included among the provisions set forth in § 106.
The Seventh Circuit Holds Taxes Paid to IRS Are Not Avoidable Because No “Actual Creditor” Under State Law Has Ability to Sue IRS
The Seventh Circuit in EAR was the first circuit court to address whether taxes paid to the IRS were avoidable under § 544(b) and held that they were not. In EAR, the debtor was organized as an S-Corporation and made nine tax payments to the IRS on behalf of its shareholders as a result of the pass-through taxation of S-Corporations. Eight of the transfers were made within two years and were recoverable under § 548, but one transfer was made outside the two-year period. The debtor sought to avoid that transfer under § 544(b) using the four-year statute of limitations of the Illinois UFTA.
In analyzing whether the taxes paid to the IRS were avoidable, the court first determined that there was a waiver under § 106(a)(1). Next, the court determined that substantive law did not provide an avenue for relief because of the actual-creditor requirement of § 544(b). The court reasoned that although § 544(b) allows a trustee to avoid an interest of an unsecured creditor using a state’s “applicable law” (i.e., Illinois’ UFTA), sovereign immunity would bar an actual unsecured creditor from recovering from the IRS under Illinois’ UFTA, and therefore, the IRS payment was not “voidable under applicable law.”
Ninth Circuit Finds Taxes May Be Avoided Because § 106 Includes Unambiguous Waiver of Sovereign Immunity for Claims Brought Under § 544
In reaching the opposite conclusion as the EAR court, the DBSI court held that a chapter 11 trustee was entitled to avoid payments to the IRS using § 544(b) and the Idaho UFTA. The debtors were organized as S-Corporations and made payments on behalf of the shareholders; some of the payments were made more than two years prior to the filing of the petition.
Reading §§ 106(a) and 544(b) together, the court reasoned that a trustee “need only identify an unsecured creditor, who, but for sovereign immunity, could bring an avoidance action against the IRS.” Further, because Congress understands existing laws when it legislates, and § 106(a) was added to the Bankruptcy Code after the enactment of § 544(b), § 106(a) was intended to waive sovereign immunity as a defense to state law causes of action brought under § 544(b).
Citing extensively to the EAR decision, the IRS argued that there was no actual unsecured creditor who could avoid the tax payments due to sovereign immunity, and therefore recovery under § 544(b) is barred. The Ninth Circuit Court of Appeals agreed that no actual unsecured creditor could recover from the IRS, but explained that the actual creditor requirement “does not exist in a vacuum” and that the unambiguous abrogation of sovereign immunity for § 544 “necessarily includes the derivate state law claim on which a § 544(b)(1) claim is based.” Further, the IRS’s position, which position the EAR court adopted, would effectively negate Section 106(a)(1)’s effect on Section 544(b)(1).”
Although ultimately reaching different conclusions, the Ninth Circuit Court of Appeals in DBSI applied the same two-step analytical framework for determining the IRS’s liability as the Seventh Circuit Court of Appeals in EAR — first by determining whether the government waived sovereign immunity, and second by determining whether the source of substantive law provided an avenue for relief. The Ninth Circuit Court of Appeals articulated the error of the Seventh Circuit Court of Appeals in step two — that there is an avenue for relief against the government. Section 544 and the applicable state law provide a substantive cause of action against the government because “a government does not need immunity from a suit which cannot be brought.” Further, under both the Bankruptcy Code and Idaho’s UFTA, the government may be defined as a debtor or a creditor. Thus, the court concluded that a debtor may avoid a tax payment to the IRS using a state’s UFTA under § 544(b).
The DBSI court also disagreed with two arguments that the EAR court had found persuasive. First, if Congress had wanted to limit § 106(a) only to § 544(a), it could have easily done so expressly. Second, if the only time § 106(a) could be used was against a state or municipality and in conjunction with a state law waiving sovereign immunity, then § 106(a) would be rendered superfluous because the state or municipality would already be amenable to suit without regard to § 106(a).
Important Takeaway for Unsecured Creditors Is that Greater Scrutiny Should Be Applied to Federal Taxes Paid by S-Corp, LLC and Partnership Debtors
For unsecured creditors, the result is another avenue for the recovery of avoidance claims. Although both EAR and DBSI involved S-Corps, the same potential recovery exists for all debtors that utilize pass-through taxation — partnerships and LLCs who have elected to be taxed on a pass-through basis. Committee members should scrutinize a debtor’s tax returns and consider whether the elements for a fraudulent transfer have been satisfied even if it is outside of the two-year look-back period provided for by § 548. It is uncertain, however, how long the DBSI decision will provide a potential benefit for debtors and unsecured creditors because DBSI and EAR have created a circuit split, potentially leading to a case before the Supreme Court.
 Zazzali v. United States (In re DBSI Inc.), 869 F.3d 1004 (9th Cir. 2017) (DBSI).
 In re Equip. Acquisitions Res. Inc., 742 F.3d 743 (7th Cir. 2014) (EAR) (holding that the doctrine of sovereign immunity does bar avoidance actions under § 544(b)(1) against the IRS).
 11 U.S.C. § 544(b)(1).
 In re Equip. Acquisitions Res. Inc. 742 F.3d at 746.
 11 U.S.C. § 106(a).
 However, various bankruptcy courts and district courts have addressed the issue and “nearly uniformly” agreed with the outcome of DBSI. 869 F.3d at 1013, n.11 (collecting cases).
 In re Equip. Acquisitions Res. Inc., 742 F.3d at 744-745.
 Id. at 745.
 Id. at 747.
 In dicta, the EAR court also pondered whether there were constitutional barriers to permitting avoidance under § 544(b). First, avoidance under § 544(b) would be barred under the Appropriations Clause, because states cannot recover money from the federal government unless approved by an act of Congress. Id. at 747-48. Second, avoidance would be barred under the Supremacy Clause; in a law school throwback, the court cited McCulloch v. Maryland, 17 U.S. 316 (1819), for the proposition that the Supremacy Clause “prevents states from enabling their residents to recover tax payments directly from the United States.” Id.
 869 F.3d 1004, 1007-08.
 Id. at 1010.
 Id. at 1011-13.
 Id. at 1010.
 Id. at 1011-12.
 Id. at 1013-14.
 Id. at 1014-15.
 The court also disagreed with the Seventh Circuit’s conclusions grounded in constitutional law. It rejected the Appropriations Clause argument based on the fact that the Bankruptcy Code distinguishes between avoidance, which turns on state law, and recovery, which is governed by federal law, § 550. Id. at 1014-15. It rejected the Supremacy Clause argument by pointing out that § 544 does not authorize a trustee to bring a state law cause of action against the IRS, but rather it “permits a trustee to pursue a federal cause of action in bankruptcy court.” Id. at 1015-16.
 Id. at 1014-15.