Inevitably during a bankruptcy proceeding, a debtor-in-possession (or court-appointed trustee) will initiate litigation to recover funds that had been fraudulently transferred to a third-party. When the target of such litigation is the federal government, complex questions involving sovereign immunity arise that are not easily answered. Can a state-law-based avoidance action be maintained against the Internal Revenue Service to recover pre-petition federal income tax payments? Until last month, no circuit court of appeals had fully addressed this issue. Recently, however, the U.S. Court of Appeals for the Seventh Circuit found in In re Equipment Acquisition Resources, No. 13-1480 (7th Cir. February 4, 2014), that notwithstanding Section 106(a)(1), a fraudulent conveyance action asserted under Section 544 of the U.S. Bankruptcy Code was barred to the extent the underlying state law upon which the action was based independently imposed sovereign immunity restrictions. The Seventh Circuit’s opinion diverges from all prior bankruptcy and district court decisions, and will likely impact the future recovery of certain pre-petition tax payments.

In 2009, Equipment Acquisition Resources Inc. (EAR) commenced its bankruptcy proceeding. Prior to filing, it had made nine federal income tax payments on behalf of its shareholders. Eight of those payments occurred within two years prior to bankruptcy, while the ninth was outside that timeframe. As debtor-in-possession, EAR filed suit against the federal government to recover all nine payments pursuant to Sections 548 and 544 of the Bankruptcy Code. While Section 548(a)(1) allows avoidance of transfers made within two years prior to bankruptcy, Section 544(b) is governed by the statute of limitations contained within the applicable state fraudulent transfer law. In this case, Illinois provided a four-year “look back period,” thereby allowing EAR to seek recovery of all nine payments.

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