Wednesday, October 12, 2022

Evaluating Fraudulent Transfer Liability for Pass-Through Tax Distributions – Start with the F-Squared Opinion

By Peter J. Klock, II
Miami, Florida 


Generally speaking, when a corporation pays dividends or distributions to its shareholders, the law does not consider the corporation to have received “reasonably equivalent value” in exchange for the payments.  For a solvent corporation authorizing and paying dividends in the ordinary course of business, the lack of reasonably equivalent consideration received in exchange for the dividends is a non-issue.  But where a corporation is insolvent, the dividends paid leave it with unreasonably small capital, or it is unable to pay its debts as they mature, dividends paid to shareholders are susceptible to being clawed back via, among other things, claims for the avoidance of constructively fraudulent transfers under applicable state or federal law.

            While resolution of such claims typically hinges on the solvency or insolvency of the corporation at the time of the transfers at issue, under narrow circumstances, defendants may be able to defeat efforts to claw back distributions made for the purposes of paying pass-through taxes.  In her recent opinion in the matter of In re: F-Squared Investment Management, LLC, 633 B.R. 663 (Bankr. D. Del. 2021), Bankruptcy Judge Silverstein thoughtfully analyzed several cases dealing with claims to claw back tax distributions and explained the reasoning succinctly, stating, “a transfer is not fraudulent if creditors are ‘no worse off’ as a result of the challenged transactions.”  

In the case before her, the debtor (a limited liability company) had made a number of pre-petition transfers to its members to pay their pass-through tax obligations.  After the debtor filed for chapter 11 protection, the trustee of the liquidating trust brought a dozen adversary proceedings seeking to avoid distributions to the members, including the tax distributions, as fraudulent transfers.  At the summary judgment stage, Judge Silverstein carved out and granted summary judgment in favor of the defendants on the claims to recover the tax distributions, finding that they had been made for reasonably equivalent value.  Critical to her determination was the fact that the debtor had previously converted from a C-Corp to an LLC, and its shareholders were induced to approve the conversion by a promise that the converted LLC would make quarterly distributions sufficient to cover their pass-through tax obligations.  The operating agreement of the LLC also expressly stated that the members were entitled to receive tax distributions sufficient to cover their pass through obligations, and the tax distributions were actually in amounts commensurate with estimated pass-through taxes (i.e., for periods in which the debtor did not profit, it did not issue tax distributions).

Under these circumstances, the debtor was no worse off due to its payment of the tax distributions.  Had the transferees not approved the conversion, the debtor would have had to pay income tax on its revenue, and the debtor was therefore no worse off as a result of the conversion and payment of distributions (which the Court viewed as one cohesive transaction) to cover pass-through taxes.  For that reason, Judge Silverstein distinguished the case before her from a case which did not involve conversion from a C-Corp to an LLC or S-Corp premised upon the payment to members or shareholders of funds to pay pass-through tax liability.

Bankruptcy trustees, insolvency litigators, and corporate attorneys alike should take heed of the F-Squared opinion and the cases discussed therein.  For those prosecuting or defending claims for the avoidance of fraudulent transfers, the merits of the claim will likely turn on the factors identified by Judge Silverstein.  For those organizing or converting to pass-through entities, the members’ or shareholders’ potential liability for such claims will likely turn on the language of the operating agreement or by-laws. 

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