In a bankruptcy proceeding, trustees can use state fraudulent transfer law to “claw back” certain prebankruptcy payments made by the debtor. Those funds are then available for distribution to creditors as part of the debtor’s estate. The Ninth Circuit Court of Appeals recently held that the IRS is not exempt from these clawback claims. In re DBSI, Inc., No. (Aug. 31, 2017) In addressing this issue a few years ago, the 7th Circuit Court of Appeals reached the opposition conclusion. In re Equipment Acquisition Resources, Inc. (“EAR”), 742 F.3d 743 (7th Cir. 2014). It looks like this is an issue that the US Supreme Court will need to resolve.

DBSI, Inc. and its affiliates were a Ponzi scheme. They engaged in the acquisition, development, management, and sale of commercial real estate properties throughout the United States. They used new investor funds to meet existing obligations. This scheme eventually caught up with them. Several of the company insiders were indicted and later convicted of fraud.

The DBSI trustee obtained a bankruptcy court order directing the IRS to return approximately $13.4 million of tax payments that DBSI made on behalf of the fraudsters. The IRS appealed that order to the district court.

While the IRS’s appeal was pending, the Seventh Circuit addressed the exact same issue and came to the opposite conclusion as the bankruptcy court. The district court was not persuaded by the Seventh Circuit’s reasoning, and affirmed the bankruptcy court’s ruling. Nor was the Ninth Circuit.

The Ninth Circuit did not agree with the IRS and Seventh Circuit’s position that a clawback of the IRS tax payments runs afoul not only of sovereign immunity, but also potentially of the Appropriations Clause and the Supremacy Clause. EAR, 742 F.3d at 747–48. The Ninth Circuit’s decision is consistent with the majority of district and bankruptcy courts that have addressed this issue.

The Ninth Circuit’s decision is available here: http://cdn.ca9.uscourts.gov/datastore/opinions/2017/08/31/16-35597.pdf