Google+ Followers

Monday, April 29, 2013

Pass-Through Entities, Tax Payments and Fraudulent Transfer Law

In the latest ABI Journal, I came across an article by Karen Cordry entitled "Paying the Owner's Taxes as a Fraudulent Conveyance? Maybe Not".  It discusses two recent decisions, In re Kenrob Info. Tech. Solutions, Inc. 474 B.R. 799 (Bankr. E.D. Va. 2012) and In re Northlake Foods, Inc., 483 B.R. 247 (M.D. Fla. 2012) , each of which held that a subchapter S corporation's payment of a shareholder's pass-through tax liability on the S corp's income was not a fraudulent transfer, because the S corps and their creditors were no worse off than if the corporation had been a C corp. More precisely, they hold that the election to be an S corp eliminated the debtor's independent tax liability and this provided "reasonably equivalent value" for it to pick up the tax liability incurred by its owner by virtue of the pass-through.

I think it is very strange that both decisions explicitly disregard a much simpler route to the same result, even though the opinions reflect that the more direct reasoning was presented to them.

In each case, there was a pre-petition agreement in place between the debtor corporation and its shareholders that obliged the debtor to pay, or reimburse its owner for paying directly, the tax liability the owner incurred by virtue of the pass-through rules.  Those agreements created, the defendants argued in each case, an antecedent debt.  Strangely, the opinions both pass over this argument and go right to the benefit the corporation received by being an S corp. (It appears that the lower court in Northlake Foods did adopt that argument, but the opinion on appeal explicitly chooses to ignore it). Section 548(d)(2)(A) defines "value" to include "satisfying or securing an antecedent debt".   Section 3 of the UFTA contains similar language. And paying a dollar to reduce a dollar of debt is obviously "equivalent" -- so equivalent that it's obviously "reasonably equivalent".

So finding a payment that merely satisfies a liability under a pre-existing contract answers the fraudulent transfer inquiry itself without further inquiry.  It appears that neither plaintiff sought to avoid the agreement in question (in the Northlake case, it is clear that the agreement fell outside the clawback period of the fraudulent transfer statute), so the debt was clearly a valid antecedent debt for analytic purposes.  Thus, every dollar of payment of taxes simply reduced a corresponding dollar of valid debt under the contract.  That dollar-for-dollar equivalence is clearly "reasonably equivalent debt".

What amount of tax liability the debtor would or would not have incurred in some alternative universe in which it was a C corp seems unnecessary to examine. That sort of "alternate universe comparison" seems to create a very big opening for defendants.  For example, imagine a case where a shareholder incurs a debt related to her business in her own name.  Then she has the corporation pay it off.  The logic of the Kenrob and Northlake courts seems to suggest that, because the corporation's creditors are no worse than if the corporation had undertaken the debt in the first place, there is no fraudulent transfer.  It's hard to distinguish that fact pattern from the fact pattern blessed by those two opinions, unless labeling the liability "tax" somehow determines the outcome by itself, although neither of the opinions so states. But that transaction has always been thought of as a quintessential fraudulent transfer, which leads me to think the reasoning of these opinions is overbroad, and the results should have been based on the clearer statutory foundation upholding satisfactions of antecedent debts.