The trustee of a distribution trust (created under a debtor’s confirmed chapter 11 plan of reorganization) sought to recover a dividend paid to a shareholder as a constructive fraudulent transfer. The bankruptcy court dismissed the case, and the district court affirmed. On appeal to the 11th Circuit, the issue was whether the debtor received “reasonably equivalent value” for the shareholder dividend payment obligation.
The debtor (Northlake) owned approximately 150 Waffle House restaurants. Originally Northlake was a Subchapter C corporation for federal tax purposes – meaning that it paid taxes on income at the corporate level, so that any dividends to shareholders would be subject to double taxation (i.e., at both the corporate and shareholder levels). In contrast, if a corporation elects to become a Subchapter S corporation, the corporation is treated as a “pass through” entity – meaning that income is passed through and taxed at the shareholder level, but not the corporation level.
In the early 1990s, the defendant shareholder (Stephens) executed a shareholders agreement. Under the agreement, if Northlake elected to become an S corporation, it would pay a dividend to shareholders at least annually that would be sufficient to cover “all income tax, state and federal, attributable to that portion of the Corporation’s income included in such Shareholder’s income in the year preceding the year of payment of the dividend.”
- Northlake elected to become an S corporation in 2005.
- In 2006 the debtor’s board of directors authorized a cash dividend to Stephens equal to his personal income tax attributable to his share of the debtor’s taxable income for 2005 (~$95,000).
- This dividend was paid in 2006.
- Northlake filed a chapter 11 bankruptcy in 2008.
In 2010, the distribution trustee filed a complaint in the bankruptcy court to avoid the 2006 dividend as a fraudulent transfer under both (i) the applicable state uniform fraudulent transfer act (asserted pursuant to the strong arm powers under Section 544 of the Bankruptcy Code) and (ii) Section 548 of the Bankruptcy Code on the basis that (1) the debtor was insolvent or rendered insolvent at the time of the dividend payment, and (2) the debtor did not receive reasonably equivalent value for the payment.
The bankruptcy court concluded that the debtor received “reasonably equivalent value,” and thus the transfer was not a fraudulent transfer on two grounds:
- Value is defined to include satisfaction of an antecedent debt. The 2006 dividend was in satisfaction of an antecedent debt created by the shareholder’s performance under the shareholders agreement that constituted reasonably equivalent value. (See “Reasonably Equivalent Value” Meets Debt Recharacterization.)
- The Subchapter S election itself constituted reasonably equivalent value to the debtor. Without that election, the debtor would have had to pay the income tax directly.
The district court affirmed on the basis that the Subchapter S election was reasonably equivalent value for the dividend.
As an aside, the trustee also sought to recover from the defendant shareholder on the basis that the dividend was illegal under state law. However, apparently applicable state law provides a cause of action only against directors who declare the dividend, and not against shareholders who receive the dividend. (The shareholder might not have fared as well under the law of a different state. Many states also allow claims against shareholders under appropriate circumstances.)
On review, the only question for the 11th Circuit was whether the S corporation election provided reasonably equivalent value for the dividend. The court set the stage by quoting from one of its prior decisions (citation omitted):
“The purpose of voiding transfers unsupported by reasonably equivalent value is to protect creditors against the depletion of a bankrupt’s estate. Therefore, this provision does not authorize voiding a transfer which confers an economic benefit upon the debtor.” Where an economic benefit is present, “the debtor’s net worth has been preserved, and the interest of the creditors will not have been injured by the transfer.”
The trustee contended that there was no evidence in the record and a fact intensive inquiry was required to determine the value of the S corporation election. While acknowledging that some cases may warrant an inquiry, in the court’s view this case was not one of them. The benefit received by the debtor was plain: The shareholder agreed to accept tax liability in exchange for the debtor’s obligation to reimburse the taxes. It gave the debtor greater flexibility to shift its tax status and had the benefit of freeing up cash since the debtor did not need to reimburse the shareholder until the year after the shareholders incurred the taxes.
The court also rejected the trustee’s contention that the bankruptcy court should have taken evidence on whether the money the debtor paid to shareholders after the S election was more than the money it would have paid directly if it had not made the election. In affirming the lower court decisions, the 11th Circuit commented that “the concept of reasonably equivalent value does not require a dollar-for-dollar transaction.”
Note that timing can be everything. Although payment on account of an antecedent debt is one of the elements for a preference claim, for an insider the transfer must be made within one year prior to the bankruptcy. Since the dividend payment was within two years but more than one year prior to the bankruptcy, fraudulent transfer claims were still timely, while a preference claim was not.
Vicki R. Harding, Esq.