Restructuring

Contributed by Alexander Woolverton.
Recently, the Eleventh Circuit Court of Appeals issued a decision in Menotte v. United States (In re Custom Contracting LLC) that serves as a harsh reminder of the consequences of being on the wrong side of unfavorable facts (if not unfavorable law).  In Menotte, a chapter 7 trustee attempted to recover estimated income tax payments made by an insolvent debtor, on behalf of its principal, to the IRS.  The problem?  The IRS had already refunded the money to the debtor’s principal, who never returned the money to the debtor.  Though the bankruptcy court found in favor of the trustee, the district court reversed the decision.  On appeal, the Eleventh Circuit held that the IRS could not qualify as an “initial transferee” under section 550 of the Bankruptcy Code on account of estimated income tax payments because the IRS already had refunded the payments.
Background
In 2006, Brian Denson formed Custom Contracting, LLC as a single-member LLC structured as an S-corporation.  As an S-corporation, the debtor did not pay federal income tax.  Instead, profits—if any—passed through to Denson who then paid taxes on income earned through the Custom Contracting.
In 2008, Custom Contracting paid Denson’s estimated tax payments totaling $26,380, and listed the payment as a distribution to Denson.  However, Custom Contracting operated at a loss in 2008, leaving Denson without any tax liability, accordingly obligating the IRS to refund the money.  The IRS refunded the money to Denson, who should have returned the money to Custom Contracting.  Unfortunately, that never happened.
On July 15, 2009, Custom Contracting filed a petition under chapter 7 of the Bankruptcy Code in the United States Bankruptcy Court for the Southern District of Florida.  After the chapter 7 trustee was appointed, she commenced an adversary proceeding against the IRS in the bankruptcy court seeking to avoid the 2008 transfer, among others.  Through the avoidance action, the trustee alleged that the IRS was the initial transferee of a constructively fraudulent transfer because the transfer was made while the debtor was insolvent.  Or, as the Court of Appeals for the Eleventh Circuit put it, the trustee sought to compel the “IRS to refund the money for a second time.”
The bankruptcy court agreed with the trustee, ruling that the debtor was insolvent at the time of the transfer and that the IRS qualified as an initial transferee.  The district court reversed.  It recognized the need for a “flexible, pragmatic, equitable approach,” and that “analyzing the transaction in its entirety” revealed that the IRS was simply acting as an intermediary, and was thus not liable as an initial transferee under section 550 of the Bankruptcy Code.  On further appeal to the Eleventh Circuit, the Court of Appeals adopted the reasoning of the district court, holding that the IRS did not in this instance qualify as an initial transferee, and accordingly that the 2008 transfer could not be avoided.
Section 550 and the “Mere Conduit” Exception
Section 550(a) of the Bankruptcy Code gives the debtor or trustee the ability to recover transfers that have been avoided under the Bankruptcy Code from “the initial transferee of such transfer or the entity for whose benefit such transfer was made; or any immediate or mediate transfer of such initial transferee.”  In Menotte, the debtor transferred $26,380 to the IRS.  Later, the IRS refunded that money to Denson, but Denson never returned the money to the debtor.  Thus, to be liable to return the money it received from the debtor, the IRS must qualify as “an initial transferee” of improperly transferred property.
Read literally, where a transfer is avoided under the Bankruptcy Code, section 550 would permit a trustee to recover the transferred property from the first person to receive it (i.e. the “initial transferee”), regardless of the circumstances.  Because there is “no hint in the legislative history that [section 550] was intended to make an innocent link in the commercial chain bear the loss of a fraudulent or preferential transfer that has vanished beyond the trustee’s reach,” courts fashioned what is known as the “mere conduit exception.”  To be considered a “mere conduit,” a party must show (1) it did not have control over the assets received, and (2) it acted in good faith and as an innocent participant in the fraudulent transfer.  In this case, the parties agreed that the good faith prong of the test had been met; the question before the Eleventh Circuit was whether the IRS satisfied the control prong.
In the Eleventh Circuit, legal control over the assets received is a key inquiry when determining whether assets can be recovered under section 550.  But this alone is not always sufficient.  For instance, if the transferee owes obligations to the transferor, courts “must consider both the initial recipient’s legal rights to the funds at issue as well as any existing obligations.”  This requires a holistic analysis of the transaction in question.  Generally, however, when a transferee receives money as a payment of an existing debt, the recipient “exercises sufficient control to be held liable as an initial transferee.”  Where, however, a bank receives money as a deposit into an account, courts have held that the bank does not qualify as an initial transferee because, despite its ability to put the funds to use, the bank’s “obligations owed to the transferor—namely to return the funds upon request—are sufficiently important” that courts do not hold the bank liable as an initial transferee.
The IRS is Not an “Initial Transferee” of Refunded Estimated Income Tax Payments
The Menotte court compared the IRS’s receipt of estimated income tax payments to a bank’s receipt of a deposit and, accordingly held that the IRS did not, in this instance, qualify as an initial transferee for purposes of section 550.  The court reasoned that Denson never “actually owe[d] income taxes for 2008.”  Rather, the payments were on account of expected tax liabilities.  Accordingly, the IRS held the money “always subject to the looming possibility” that it would have to refund the money to Denson.  With those circumstances in mind, the court held that the IRS’s contingent obligation to refund the money was sufficiently similar to a “bank’s obligation to return deposited funds upon request.”
The court took note of the fact that the IRS could—and did—actually put the funds to use during the period in between its receipt of the estimated tax payment and its issuance of the refund.  The court clarified that, nevertheless, the control test turns on the recipient’s legal rights and obligations, and because the IRS’s use of the funds did not alter those rights or obligations with respect to the money, its use was deemed irrelevant.  Further, the court noted that the IRS’s obligation to refund the money was not fixed until the debtor or Denson’s tax liability was determined, while a bank always has the obligation to return money deposited with it.  Again, the court found this distinction to be inconsequential because the IRS’s rights “were circumscribed by the obligations owed such that the transfer to the IRS could not be considered the payment of a debt.”
Conclusion
In Menotte, the chapter 7 trustee’s defeat was perhaps due to the unfairness of requiring the IRS to repay money it had already properly refunded.  It is unclear whether the court’s holding would have been the same if it found that the IRS had actually been owed the funds it received (and later refunded), as the court certainly cited this distinction as relevant to its analysis.  Although not discussed by the court, its ruling left the trustee with the option of pursuing Denson for the refunded money.  It is not clear why the trustee did not seek to recover the funds from Denson in the first place, although the possibility that she may not have been able to collect the funds from Denson may have played a role.