Rudolph J. DiMassa Jr., left, and Drew McGherin, right, of Duane Morris. Rudolph J. DiMassa Jr., left, and Drew McGerhin, right, of Duane Morris.

In In re Gaither, Case No. 18-01317, Adv. Pro. No. 18-80040; 2018 WL 6287971, the U.S. Bankruptcy Court for the District of South Carolina held that Bankruptcy Code Section 544(b) permitted a trustee to step into the shoes of the Internal Revenue Service and employ the Federal Debt Collection Procedures Act to seek to avoid a transfer of disclaimed settlement proceeds. In so ruling, the court joined a number of other bankruptcy courts in establishing a bankruptcy trustee’s ability to seek and recover debts that, according to the defendants in this case, were collectible exclusively by the IRS.

Background

Cole and Anita Gaither were named as the personal representatives of their son’s estate following an aviation accident that resulted in their son’s death. On Jan. 26, 2015, Mr. and Mrs. Gaither filed a complaint against various parties seeking damages arising from the accident and the resulting death. Ultimately, the parties to this litigation agreed upon a settlement of $1.3 million in satisfaction of the Gaithers’ claims, resulting in a net recovery of $830,183.67. The settlement was approved by the Charleston County Court of Common Pleas on May 6, 2015. On that same date, the Gaithers disclaimed their rights to the settlement payment. Accordingly, the settlement amount passed to the Gaithers’ three surviving children in equal shares.

On March 16, 2018, Mr. and Mrs. Gaither filed for protection under Chapter 7 of the Bankruptcy Code. The Internal Revenue Service submitted a claim in the bankruptcy case for $787,239.85 in amounts due and owing by the debtors to the IRS. Of this amount, $332,023.52 was claimed to be secured.

In light of the IRS’s claim, on June 4, 2018, the Chapter 7 trustee for the debtors’ estates initiated an adversary proceeding demanding the avoidance of the disclaimed settlement proceeds, alleging that the Gaithers’ disclaimer of any interest in these proceeds was both actually and constructively fraudulent. In her complaint, the trustee alleged that the debtors’ tax liability was outstanding at the time of the disclaimer and, as such, pursuant to 28 U.S.C. Section 3304(a)(1) and the Federal Debt Collection Procedures Act (FDCPA), the transfer accomplished through the disclaimer was avoidable by the IRS. By extension, the trustee asserted that she was entitled to avoid such transfers on behalf of the IRS by virtue of Bankruptcy Code Section 544(b). The defendants to the action, the debtors’ surviving children, responded by filing a motion to dismiss the complaint.

Opinion of the Bankruptcy Court

In their dismissal motion, the defendants alleged that the trustee was without authority to initiate or maintain claims that are exclusively held by the IRS. The defendants additionally asserted that, even were the trustee able to step into the shoes of the IRS, the FDCPA did not qualify as “applicable law” under Code Section 544(b).

In the complaint, the trustee asserted that Code Section 544(b) permits trustees to step into the shoes of the IRS and bring actions on behalf of the IRS. Under Code Section 544(b), a “trustee may avoid any transfer of an interest of the debtor in property or any obligation incurred by the debtor that is voidable under applicable law by a creditor holding an unsecured claim … [.]” Thus, the bankruptcy court acknowledged that, as courts have “almost universally held” that trustees may step into the shoes of “actual unsecured creditors,” it first had to determine whether the IRS held an allowable unsecured claim for purposes of Code Section 544(b).

In making such a determination, the court first addressed whether the IRS itself was entitled to recovery of the disclaimed settlement proceeds notwithstanding the debtors’ disclaimer. The court noted that, while under South Carolina law, the legal consequence of a disclaimer (such as the one at issue here) would be as if the transfer had never occurred. At the same time, the court recognized Supreme Court precedent issued in Drye v. United States, 528 U.S. 49 (1999) making clear that such a disclaimer would not defeat a federal tax lien. Consequently, the court concluded that the IRS held a viable claim. It went on to reason that, should the trustee be permitted to step into the IRS’s shoes, the trustee could avail itself of any law the IRS might use to avoid the disclaimer.

The court then engaged in an analysis of whether the trustee could step into the shoes of the IRS to assert such claim. The court first addressed a decision rendered by the U.S. Court of Appeals for the Fourth Circuit in Schlossberg v. Barney, 380 F.3d 174 (4th Cir. 2004), cited in support of the defendants’ position that a trustee is generally prohibited from asserting claims on behalf of the IRS or the federal government. In Barney, the Fourth Circuit Appellate Court addressed whether Bankruptcy Code Section 544(a)(2) vested a trustee with the rights of the IRS as a hypothetical creditor to pierce the entireties exemption from certain tax liabilities for the benefit of individual creditors of a debtor’s estate. In rendering its decision against the trustee in that case, the appellate court held that the IRS did not qualify as a “creditor who extends credit” to a debtor, as required under Code Section 544(a)(2) and, therefore, the trustee could not assert the collection powers of the IRS to reach the debtor’s property.

The bankruptcy court in Gaither highlighted the fact that Code Section 544(b) was not at issue in Barney; instead, the avoidance claim in Barney was brought under Code Section 544(a). The court emphasized that “Sections 544(a) and 544(b) are different and should be analyzed separately.” It noted that Section 544(a) limits recovery to instances in which the trustee steps into the shoes of a “creditor that extends credit” to a debtor, while Section 544(b) extends such recovery to any “creditor holding an unsecured claim.” Therefore, the court found that the “defendants’ reliance on Barney is unfounded,” because the trustee’s avoidance powers in this case derive from Code Section 544(b).

After analyzing the foregoing concepts together with related case law, the bankruptcy court narrowed the focus of its analysis to one of statutory construction. Notwithstanding the varying interpretations of Code Section 544(b), the bankruptcy court held that, since the IRS held an allowed unsecured claim, the trustee was indeed permitted to step into the IRS’s shoes and utilize the collection powers otherwise available to the IRS.

The court then turned to whether the FDCPA qualified as “applicable law” under Code Section 544(b). First, the defendants asserted that the IRS and, by extension, the trustee, were restricted from utilizing the FDCPA, as the IRS was limited to the provisions of the Internal Revenue Code in collecting debts. The court, however, dismissed these assertions, noting that not only was the support for the defendants’ arguments misplaced, but the IRS’s Internal Manual expressly lists the FDCPA as a tool available to the IRS in the context of collecting fraudulent transfers. Thus, the court concluded that the provisions of the FDCPA are in fact available to the IRS in its collection efforts.

The bankruptcy court then discussed the current circuit split on the issue of whether the FDCPA constitutes “applicable law” for purposes of Code Section 544(b). The court reviewed a number of judicial decisions in which the issue was addressed, and once again emphasized that the majority of such decisions largely rested on the plain language of the statute. Adhering to that approach, the bankruptcy court turned to the statutory text, noting that the “plain language of [the term] ‘applicable law’ is not limited to any particular law, and thus, a trustee may use any law available to avoid a transfer.” As such, the trustee in this case was indeed permitted to step into the shoes of the IRS and utilize the FDCPA to avoid the transfers at issue here.

Conclusion

In In re Gaither, the Bankruptcy Court for the District of South Carolina joined a growing majority of courts in clarifying a bankruptcy trustee’s ability to assert claims held by the Internal Revenue Service for the benefit of all creditors, and to employ federal law in doing so. It is important to note, however, that the bankruptcy court’s decision in this case was rendered in connection with the defendants’ motion to dismiss: the fact that the trustee’s complaint survived that motion does not necessarily mean that she faces an easy road to recovery of all of the $830,183.67 in settlement proceeds.

Chief among the court’s initial inquiries was whether the IRS (and, by extension, a Chapter 7 trustee) was entitled to recovery of the disclaimed settlement proceeds notwithstanding the debtors’ disclaimer: by operation of South Carolina law, the legal consequence of the debtors’ disclaimer is that the debtors never received these settlement proceeds. In addressing the impact of South Carolina’s disclaimer statute on the trustee’s claim, the court cited the Drye decision, in which the Supreme Court held that such a disclaimer would not defeat a federal tax lien. Therefore, the Supreme Court’s holding in Drye creates the inference that only the secured portion of the IRS’s claim can trump the operation of the South Carolina disclaimer law, and any unsecured portion of that claim could otherwise be extinguished. As a result, the trustee could be deemed to have no right to recover the unsecured portion of its claim, and Code Section 544(b) (which, as noted above, is applicable only to creditors holding unsecured claims) would not apply to the remaining secured portion of the IRS’s claim. Whether the trustee could thereafter sustain a fraudulent transfer action with respect to the secured portion of the IRS’s claim would depend on, among other things, applicable statutes of limitations.

Rudolph J. Di Massa Jr., a partner at Duane Morris, is a member of the business reorganization and financial restructuring practice group. He concentrates his practice in the areas of commercial litigation and creditors’ rights.

Drew S. McGehrin, an associate at the firm, practices in the areas of commercial finance, financial restructuring and bankruptcy.