Supreme Court Ruling Shields IRS in Bankruptcy Fraud Case

"Internal Revenue Service building sign"

The Supreme Court has ruled that the IRS cannot be forced to return payments deemed fraudulent in bankruptcy cases, reinforcing the federal government’s sovereign immunity against state law claims.

Quick Takes

In an 8-1 decision, the Supreme Court ruled that the IRS is protected by sovereign immunity from returning payments deemed fraudulent under state law in bankruptcy cases.
The case involved $145,000 that All Resort Group Inc. paid to settle tax debts of company principals three years before declaring bankruptcy.
Justice Ketanji Brown Jackson wrote the majority opinion while Justice Neil Gorsuch was the lone dissenter.
The ruling prevents bankruptcy trustees from using state fraudulent transfer laws to recover payments made to the IRS beyond the typical two-year lookback period.
The decision significantly impacts how bankruptcy trustees can pursue recovery of assets transferred to government entities.

Supreme Court Reinforces IRS Sovereign Immunity

In a landmark ruling, the Supreme Court has reinforced federal government protection against bankruptcy clawbacks in the case United States v. Miller. The 8-1 decision, authored by Justice Ketanji Brown Jackson, determined that sovereign immunity shields the IRS from state law claims related to allegedly fraudulent transfers in bankruptcy proceedings. This ruling overturns a Tenth Circuit Court decision that had allowed a bankruptcy trustee to pursue recovery of funds paid to the IRS more than two years before a bankruptcy filing, significantly limiting the ability of trustees to recover such payments from government entities.

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The case centered around All Resort Group Inc., which paid $145,000 to the IRS three years before filing for bankruptcy to settle the personal tax debts of company principals. When the company later filed for bankruptcy, the trustee sought to recover this payment by arguing it was a fraudulent transfer under Utah state law.

Legal Implications of the Court’s Decision

The Court’s decision has significant implications for bankruptcy proceedings nationwide, particularly regarding the recovery of payments made to government entities. The ruling clarifies that while the Bankruptcy Code waives sovereign immunity for certain federal claims, this waiver does not extend to underlying state law claims that might be incorporated into federal bankruptcy actions. Justice Jackson emphasized that sovereign immunity waivers must be construed narrowly, with ambiguities resolved in favor of the government. “Waivers of sovereign immunity are jurisdictional provisions that empower courts to hear claims against the government but do not themselves typically create any new substantive rights against the government,” wrote Justice Jackson.

The decision resolves a split among federal appeals courts on whether bankruptcy trustees can recover funds paid to the government beyond the standard two-year lookback period. Previously, the Fourth, Ninth, and Tenth Circuits had rejected the Seventh Circuit’s approach, creating legal uncertainty that this ruling now clarifies. Bankruptcy practitioners note that single asset debtors might still pursue recovery through Section 550 of the bankruptcy code, which allows for the waiver of sovereign immunity and disgorgement of funds in certain circumstances.

Technical Aspects of the Court’s Ruling

The Court’s decision delves into technical aspects of bankruptcy law, particularly the interaction between Section 544(b) of the Bankruptcy Code and state fraudulent transfer laws. Section 544(b) allows trustees to avoid transfers that an “actual creditor” could void under applicable law. The Court held that while Section 106(a) of the Bankruptcy Code waives sovereign immunity for the federal claim under Section 544(b) itself, this waiver does not extend to the state law claims that provide the “applicable law” for the trustee’s action.

The Court also highlighted the distinction between Section 544(a) and Section 544(b) of the Bankruptcy Code. Unlike Section 544(a), which creates hypothetical creditors with specific powers, Section 544(b) requires an actual creditor who could void the transfer under applicable law. This distinction proved crucial to the Court’s reasoning, as it underscored that a trustee using Section 544(b) can only exercise rights that an actual creditor would possess – and no actual creditor could overcome the government’s sovereign immunity under state law.

Dissenting Opinion and Future Implications

Justice Neil Gorsuch was the lone dissenter in this case, breaking with the majority’s interpretation of sovereign immunity in the bankruptcy context. His dissent underscores the continuing debate about the proper scope of governmental immunity in modern bankruptcy proceedings. The 8-1 decision leaves little room for immediate legal challenges but may prompt congressional action if lawmakers determine that the ruling unduly protects government agencies from the consequences of accepting potentially fraudulent transfers.

For bankruptcy practitioners and trustees, the ruling means adopting new strategies when dealing with pre-bankruptcy transfers to government entities. The decision effectively limits recovery actions against government agencies to the two-year lookback period specified in the Bankruptcy Code, rather than the longer periods often available under state fraudulent transfer laws. This protection of government funds comes at a time of increased scrutiny over federal spending and tax collection practices, making the ruling particularly significant for conservative taxpayers concerned about government accountability.