Now Updating
In re Fansteel Foundry Corporation

Summarizing by Bradley Pearce

Menotte v. US (In re Custom Contractors, LLC)

Citation:
2014 WL 1226852
Tag(s):
Ruling:
The Eleventh Circuit held that the Internal Revenue Service was not liable as an "initial transferree" under 11 U.S.C. § 550(a)(1) as to pre-paid taxes that were otherwise avoidable by the trustee, extending its "mere conduit" jurisprudence. The avoidance rules of § 550 only permit the avoidance of a transfer to an "initial transferee." The Eleventh Circuit, in Martinez v. Hutton, 628 F.3d 1312 (11th Cir. 2010), found that certain entities would not qualify as an initial transferee, even if in a literal sense some property was transferred to them by the debtor, if the transferee did not obtain full legal rights to the property. Specifically, the Eleventh Circuit articulated a two part "mere conduit" test in Martinez, which establishes a defense to an avoidance action if the transferee can show "(1) that they did not have control over the assets received. . . . and (2) that they acted in good faith and as an innocent participant in the transfer." Id. at 1323. In the context of this exception, the Eleventh Circuit defines "control" to mean "legal control over the assets received, such that they have the right to use the assets for their own purposes." In turn, consideration of legal control requires consideration of both "the initial recipient's legal rights to the funds at issue as well as any existing obligations." The Court noted that it had previously found that a depositary bank was a "mere conduit" as to funds placed in deposit, reasoning that the bank was obliged to repay the funds to the debtor on demand and did not excercise legal control over those funds. In Mennotte (apparently a case of first impression), the Eleventh Circuit extended its "mere conduit" jurisprudence to include the prepayment of taxes to the IRS. The Court found that, by analogy to a depositary bank, the IRS holds prepaid taxes in a general account commingled with other government funds, but that because tax liability has not been established, such "taxes" are always subject to potential repayment (with interest) to the taxpayer - i.e., "[s]trings were always attached to the transfer." Accordingly, as to prepaid taxes, the IRS holds such funds subject to the potential for repayment thereof to the taxpayer, and so is properly characterized as a "mere conduit" that cannot be an initial transferee under § 550.
Procedural context:
The debtor entity filed for reorganization under Chapter 11. A trustee was appointed, who filed an adversary proceeding challenging eight payments made to the Internal Revenue Service as avoidable under §§ 550(a), 544(b)(1) and 548. The bankruptcy court found that only one payment, the last of the series, was avoidable under §§ 550 and 548. The district court reversed, finding that all eight payments were not avoidable, under the Eleventh Circuit's "mere conduit" doctrine.
Facts:
The debtor entity is a single-member limited liability company with Subchapter S corporation tax treatment, such that federal income tax liability passed through to the sole member. The debtor pre-paid taxes on behalf of its owner for a number of years pre-petition. The debtor listed such payments as distributions to the member. The last of this series was refunded entirely when the debtor reported no income for that tax year. As the refund related to the member's tax liability, the refund was paid directly to the member and not the debtor entity. The member never repaid the debtor entity. The trustee characterized this (and similar transfers) as fraudulent and avoidable under §§ 550, 544 and 548, and sought to recoup those payments from the IRS..
Judge(s):
Chief Judge Carnes, Judges Wilson and Fay.

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