Transfers in Bankruptcy – The “Strong Arm” of the Bankruptcy Trustee
Overview
The U.S. legal system has a long history of allowing debtors to hold specified items of property exempt from creditors (unless the exemption is waived). This, in effect, gives debtors a “fresh start” in becoming reestablished after suffering economic reverses. Procedurally, exempt property is included in the debtor’s estate in bankruptcy, but any particular exempt asset can be removed from the bankruptcy estate if no objections to the exemption claim is made within 30 days from the meeting of the creditors. In that case, the debtor can then fully utilize the exempt asset. Only nonexempt property is used to pay the unsecured creditors.
Because of the availability of exemptions, debtors may be tempted to convert nonexempt property (such as cash) into exempt assets prior to bankruptcy filing. They may also be tempted to transfer property (either exempt or not) to a spouse or other family member to get the property out of their name. There is no general prohibition on such conversions, but courts closely examine attempted conversions with respect to the adequacy of the purchase price and the bargaining position of the parties involved. If the primary purpose of the move is to hinder, delay or defraud creditors, the conversion can be challenged. In addition, transfers made by insolvent debtors within one year of filing a bankruptcy petition in exchange for less than equivalent value may be avoidable transfers. See 11 U.S.C. § 548(a)(2).
Actual intent to defraud must generally be present, but a court may infer actual intent from the circumstances of the debtor’s conduct. In other words, a debtor could engage in actual fraud as defined by 11 U.S.C. §548 (a)(1)(A) or constructive fraud under 11 U.S.C. §548 (a)(1)(B). In addition, the funds used to acquire exempt assets must not be from the sale of collateral or as a result of wrongdoing by the debtor. In addition, some states have enacted limits on acquiring some types of exempt property (notably life insurance policies) within a specified time before bankruptcy filing.
But, if a bankruptcy trustee objects to a debtor’s transfer as being fraudulent, how soon must the trustee act to avoid the transfer? Does it matter that the IRS also has a claim against the debtor? A recent case from a bankruptcy court in Florida dealt with the issue. The answer that the court provided could serve as a wake-up call to some debtors and their legal counsel.
The Bankruptcy Code’s “Strong-Arm” Provision
The “strong-arm” provision, 11 U.S.C. §544, gives the bankruptcy trustee the authority to “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 that is allowable under section 502 of this title…” So what does that mean? Generally, when a bankruptcy trustee uses the provision, the trustee will rely on a state’s fraudulent transfer statute as the basis for avoiding transfers the debtor makes when the debtor is trying to avoid paying creditors what they are owed. The effect of using the “strong-arm” provision is that the trustee steps into the shoes of an unsecured creditor. That also means that the trustee then becomes subject to the statute of limitations applicable under state law, which is typically four years for fraudulent transfers. But what if the unsecured creditor is the federal government – the IRS?
Recent case. In In re Kipnis, 555 B.R. 877 (Bankr. S.D. Fla. 2016), an individual was a partner with another person in the general contracting business. The business had big losses which passed through proportionately to the individual who then claimed them on his 2000 and 2001 returns. In 2005, the individual transferred via quitclaim deed a condominium to his wife in accordance with a pre-marital agreement that the couple had entered into during the prior month. Later that day, the individual changed the title ownership of his bank account from his name only to include his wife along with himself as tenants by the entirety (a marital form of joint tenancy). The IRS audited the partners’ returns for 2001 and 2001 and disallowed the losses, and in 2012 the Tax Court agreed with the IRS, and little over a year later the individual (now “debtor”) filed for Chapter 11 and then converted it to Chapter 7. The IRS filed a proof of claim for $1,911,787.23. Of that amount, $25,629.51 was unsecured, but prioritized under 11 U.S.C. §507(a)(8). The bankruptcy trustee tried to avoid the transfers under state (FL) law governing fraudulent transfers. The debtor’s wife moved to dismiss on the basis that the four-year statute of limitations that applied under FL law to challenge fraudulent transfers had run and barred the trustee’s claim. She cited In re Vaughan Co., 498 B.R. 297 (Bankr. D.N.M. 2013), where the court determined that the IRS was subject to the state-based statute of limitations. However, the bankruptcy trustee cited cases from numerous other states where the courts in those states determined that the “strong-arm” statute allowed the trustee to step into the shoes of the IRS and take advantage of the 10-year statute of limitations under I.R.C. §6502(a)(1). The court agreed with the trustee, holding that In re Kaiser, 525 B.R. 697 (Bankr. N.D. Ill. 2014) was persuasive and that the court’s rationale should apply to the facts of the case. One of the key aspects of In re Kipnis was the court’s reasoning that the IRS can avoid a state’s statute of limitations because of sovereign immunity, but that a trustee can avoid it via the “strong-arm” statute which provides a derivative form of sovereign immunity.
So, the wife’s attempt to dismiss the trustee’s action was denied, but the court seemed dismayed that the court’s finding could tempt bankruptcy trustees to aggressively go after a debtor’s funds in a bankruptcy proceeding. The court stated, “The Bankruptcy Code’s strong-arm provision (Section 544) provides a bankruptcy trustee the authority to “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 that is allowable under section 502 of this title…”. The court went on to state that, “The IRS is a creditor in a significant percentage of bankruptcy cases,… “The paucity of decisions on the issue may simply be because bankruptcy trustees have not generally realized that this longer reach-back weapon is in their arsenal. If so, widespread use of [Bankruptcy Code Section] 544(b) to avoid state statutes of limitations may occur and this would be a major change in existing practice.”
Conclusion
In re Kipnis illustrates that bankruptcy trustees have a fairly strong weapon in the bag to ultimately effect larger distributions to creditors of a bankruptcy estate. When the IRS is a creditor, that weapon can be powerful and can be used, as in In re Kipnis, to reach transfers that weren’t made to avoid creditors. For bankruptcy lawyers with debtor-clients having facts similar to In re Kipnis, perhaps look into paying outstanding taxes before the debtor files bankruptcy.