No Time Runs against the King (IRS): The Golden Creditor Rule and its Discontents

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[co-authors: Emma Wheeler, and Alex Xiao]

Executive Summary

A bankruptcy court in North Carolina recently joined a growing number of courts allowing debtors and trustees to avoid prepetition transactions using the IRS’s lookback period of ten years, rather than the applicable state statute of limitations period.1 In In re Zagaroli, the Western District of North Carolina bankruptcy court found that a trustee could step into the shoes of the IRS for the purposes of avoiding a transfer under section 544(b), therefore utilizing the longer reach-back period available to the IRS. No. 18-50508, 2020 Bankr. LEXIS 3111 (Bankr. W.D.N.C., Nov. 3, 2020). In this post, we discuss not only the Zagaroli case, but also the relevant arguments surrounding the split among courts on this issue.

In re Zagaroli

The Debtor, Peter Lawrence Zagaroli, filed a chapter 7 bankruptcy petition in May 2018. Approximately seven years prior, the Debtor allegedly transferred several pieces of real property to his parents for no consideration. The trustee sought to avoid these transfers, which occurred while Mr. Zagaroli was insolvent, pursuant to section 544(b) of the bankruptcy code.

Section 544(b), also known as the golden creditor rule, allows a trustee to step into the shoes of any unsecured creditor to avoid any transfer the creditor could avoid under “applicable law.” Most states have adopted a uniform voidable transactions act that provides a statute of limitations for avoiding transfers. Under applicable North Carolina law, the statute of limitations is four years.

In this case, the trustee sought to use the IRS, which held an unsecured claim, as its golden creditor in an attempt to invoke the Internal Revenue Code as applicable law. The Internal Revenue Code, under section 26 U.S.C. § 6502, provides a ten-year period for collecting a tax.

The court, using a plain language reading of 544(b), held that the trustee could step into the shoes of the IRS to avoid the transfers under the Internal Revenue Code. The court agreed with the majority view that “applicable law” should be broadly construed to encompass the Internal Revenue Code, which the IRS could have used to recover outside of bankruptcy.

In so holding, the court rejected the transferees’ arguments that 544(b) “does not grant the trustee the power to bring actions that are grounded in tax evasion claims that are only available to the United States outside of the bankruptcy arena and that a trustee should not be able to take advantage of the immunity of the United States from the state statutes of limitation.” The court found these arguments unpersuasive, noting that the transferees’ position would leave both the trustee and the IRS without recourse to avoid transfers it would otherwise be entitled to avoid outside of bankruptcy.

Broader Context: IRS as the Golden Creditor

The holding of In re Zagaroli is hardly a surprise since a majority of bankruptcy courts’ ruling on this issue has reached the same conclusion. However, given that no circuit court has yet to address the issue, further discussion is warranted on whether the debtor or trustee can use the IRS as the golden creditor and what arguments parties have made in court so far.

The common law tradition has historically granted a longer statute of limitations to sovereign than private actors. An ancient doctrine known as nullum tempus occurrit regi, or “no time runs against the king,” was recognized by the U.S. Supreme Court in United States v. Summerlin, where the Court held that “the United States is not bound by state statutes of limitations or subject to the defense of laches in enforcing its rights.” 310 U.S. 414, 416 (1940). The modern rationale behind this rule, as articulated by the Ninth Circuit, is that “public rights, revenues, and property should not be forfeited due to the negligence of public officials.” S.E.C. v. Rind, 991 F.2d 1486, 1491 (9th Cir. 1993). This historic principle is the foundation that allows the Internal Revenue Service to preempt state law statute of limitations and be bound only by the Internal Revenue Code’s statute of limitations.

The issue then, in the 544(b) context, becomes whether the trustee can utilize the IRS’s preemption power to gain a longer claw back period. Absent a decision from the circuit level, the most notable bankruptcy court decision disapproving of the IRS as the golden creditor is In re Vaughan. 498 B.R. 297 (Bankr. D.N.M. 2013). The Vaughan court denied a trustee’s request to avoid an alleged fraudulent transfer that happened beyond the state’s 5-year statute of limitations but within that of the IRS, an unsecured creditor in the case.

The Vaughan court’s holding relied on two arguments. First, the nullum tempus doctrine does not apply because the bankruptcy trustee is not sovereign and its actions do not protect the public interest. Second, because the IRS holds unsecured claims in “a substantial portion of bankruptcy cases,” allowing the trustee to step into the shoes of the IRS would practically render the state statutes of limitations moot. Id. at 305. The Vaughan court found that Congress could not have intended this policy consequence.

A number of courts have since addressed and rejected these two arguments. See e.g., In re Gaither, 595 B.R. 201 (Bankr. D.S.C. 2018), In re Kipnis, 555 B.R. 877 (Bankr. S.D. Fla. 2016), and Hillen v. City of Many Trees (In re CVAH, Inc), 570 B.R. 816 (Bankr. D. Idaho 2017). The Kaiser court, for example, rejected the Vaughan court’s nullum tempus analysis by pointing out that 544(b) has always provided a derivative right to the trustee. Ebner v. Kaiser (In re Kaiser), 525 B.R. 697, 713 (Bankr. N.D. Ill. 2014). For these courts, first, it is not material whether the trustee is sovereign, because trustees only exercise the rights on behalf of the IRS, who may rightfully preempt state law pursuant to the Internal Revenue Code. Similarly, a majority of courts have dismissed the Vaughan court’s second, policy-oriented argument granting the IRS golden creditor status by citing the unambiguous plain language of 544(b), as in Zagaroli.

Another argument against using the IRS as the golden creditor is that the practice could potentially lead to an unlimited claw back period. See In re CVAH, Inc., 570 B.R. at 838. The 10-year statute of limitations constraining the IRS only starts to run after the taxpayer files a tax return. Because the taxpayer could theoretically delay filing the tax return for an unlimited period, the IRS and the trustee could avoid transactions for an unlimited reach-back period.

Courts have also dismissed this concern. The CVAH court noted that timeliness is only one element of a constructive fraudulent transfer claim. Id. at 838. Practically, the burden to prove the claim likely would become more onerous for the trustee the further back in time the transfer occurred from the bankruptcy petition date.

Takeaways

Although no circuit court has addressed the golden creditor rule with regard to the IRS, the Western District of North Carolina bankruptcy court joins an increasing number of bankruptcy courts in holding that “applicable law” under 544(b) includes the Internal Revenue Code and its 10-year statute of limitations.

It is also worth noting that when clawing back transactions in the shoes of the IRS, the trustee or the debtor can recover more than the amount that was owed to the IRS. At least one court found that the trustee could use the IRS as the golden creditor even where the IRS’s claims were paid in full after the commencement of the bankruptcy case. See In re Greater Se. Cmty. Hosp. Corp. I, 365 B.R. at 301. Therefore, in cases where the IRS holds an unsecured claim, the majority courts’ application of the golden creditor rule significantly increases the statute of limitations period that a debtor or transferee must analyze for clawing back transactions into the bankruptcy estate. Parties that engage in transactions with distressed companies or companies that become distressed will be exposed to a much wider window of potentially avoidable transactions. Since the IRS is so frequently a creditor in bankruptcy cases, decisions allowing a debtor or trustee to use the IRS as a golden creditor threaten to greatly expand the universe of transactions susceptible to avoidance. It remains to be seen, however, whether any circuit court will take up this issue or contradict the majority rule of the bankruptcy courts.

1 See, e.g., Vieira v. Gaither (In re Gaither), 595 B.R. 201 (Bankr. D.S.C. 2018); Mukamal v. Citibank (In re Kipnis), 555 B.R. 877 (Bankr. S.D. Fla. 2016); Ebner v. Kaiser (In re Kaiser), 525 B.R. 697 (Bankr. N.D. Ill. 2014); Alberts v. HCA Inc. (In re Greater Se. Cmty. Hosp. Corp. I), 365 B.R. 293 (Bankr. D.D.C. 2006); Shearer v. Tepsic (In re Emergency Monitoring Technologies, Inc.), 347 B.R. 17 (Bankr. W.D. Pa. 2006); Osherow v. Porras (In re Porras), 312 B.R. 81 (Bankr. W.D. Tex. 2004).

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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