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Can a Distribution to Equity Owners for Payment of Taxes Arising From Pass-Through Profits Constitute a Fraudulent Transfer?

By Joseph A. Foster, Christopher M. Dube, and Scott H. Harris

Published in NH Bar News (July 2022)

The vast majority of entities formed are set up to pass the federal tax attributes of the company’s operations through to the owners.  These so-called “pass-through” entities include limited liability companies and corporations that elect S corporation status.  Passing the tax on profits through to the owners avoids tax at the entity level.

A potential problem with “pass-through” entities is that, while the tax liability flows automatically to the owners, the company does not automatically distribute sufficient cash to pay the resulting tax.  The company could, for instance, reinvest its profits, leaving the owners with a large tax bill that they have to cover out of their own pockets.  To ensure the equity owners’ ability to pay the tax, limited liability companies and S corporations generally make distributions to cover the tax liability.

What happens when a profitable company that made tax distributions suffers a catastrophic financial reversal that lands the company in bankruptcy?  In a number of cases, a bankruptcy trustee has sued the recipients of the tax distributions to recover the payments, alleging that the payments constitute a constructively fraudulent transfer.  To make out the claim, the trustee must prove two key elements.

First, the trustee must prove the entity was insolvent at the time the tax distribution was made or became so as a result of the distribution.  Proving that an entity was “insolvent” under the Bankruptcy Code or the Uniform Fraudulent Conveyance Act is complex and often requires extensive discovery and costly expert witness analysis.

Second, the trustee must prove that the tax distribution was made for “reasonably equivalent value.”  While the term is not defined in the relevant statutes, some courts have held that a party receives reasonably equivalent value for what it gives up if it gets “roughly the value it gave.”  VFB LLC v. Campbell Soup Co., 482 F.3d 624, 631 (3d. Cir. 2007).  In re Feeley, 429 B.R. 56, 63 (Bankr. D. Mass 2010)(If a court determines that some value was exchanged, it should then “compare what was given with what was received.”) The policy here is that if the transfer made was for roughly equivalent value, it was fair to the entity and its other creditors.

Although cases addressing the issue are few, some courts have held that a tax distribution can never be for reasonably equivalent value because the tax was due from the equity owners, not the bankrupt company.  See, In re SGK Ventures, LLC, 521 B.R. 842, 859 (Bankr. N.D. Ill. 2014) (“Assuming that SGK had committed to pay its members enough cash to satisfy their tax liability for a given year, this arrangement—even if called a contract—was equivalent to a corporate dividend; fulfilling the commitment would not produce any benefit to SGK”).  See also, In re TC Liquidations LLC, 463 B.R. 257, 271 (Bankr. E.D.N.Y. 2011) (“It was improper for the Debtors to issue the Tax Dividends and essentially pay Defendants’ personal tax obligations.  There is no shown consideration provided to the Debtors for these payments.”)  These courts ignore that the company’s choice to form as a limited liability company or elect S corporation status avoids double taxation, and that may enhance the company’s ability to raise and conserve capital.

Other courts find reasonably equivalent value if the bankrupt company’s organic documents or some other binding agreement obligates the company to make the tax distribution.  See, In re Northlake Foods, Inc., 715 F.3d 1251 (11th Cir. 2013) (in which the shareholder agreement provided that if the corporation’s income ever becomes taxable to the shareholders, the corporation shall pay out of the dividend, the tax distribution was found to be for reasonably equivalent value because it conferred an economic benefit on the company); and In re Kenrob Information Technology Solutions, Inc., 474 B.R. 799 (E.D. Va. 2012) (testimony of shareholders that there was an agreement to make tax distributions was sufficient to conclude reasonably equivalent value was given).

The obligation to make the payment in a governance document need not be absolute to satisfy the requirement.  In the case of In re F-Squared Investment Management, LLC, 633 B.R. 663 (Bankr. D. Del. 2021), the debtor converted from a C corporation to a limited liability company taxed as a partnership; a change that required shareholder approval.  To convince the shareholders to vote in favor of the conversion and assuage their fears about pass-through tax liability, a provision was included in the operating agreement to pay taxes, but it was not absolute.  It provided:

5.1 (a) Tax Distributions. The Members shall be entitled to receive distributions from the Company only at the following times:

(1) With respect to any taxable year prior to the year in which the Company liquidates or sells all or substantially all of its assets, the Company will use reasonable efforts to distribute to each Member on an annual basis…

The trustee argued that the “reasonable efforts” language was not enough because the distributions were not mandatory.  The Court disagreed.  It focused on the “shall be entitled” language in the prefatory portion of the section of the operating agreement and noted that under Delaware law, “reasonable efforts” creates an affirmative obligation to act.  F-Squared, 633 at 675.

One takeaway from the cases is to be sure that the operating agreement, shareholder agreement, or other governance document obligates the company to make tax distributions to the greatest extent permitted by law.  While the law in the First Circuit remains undeveloped, having a clear contractual obligation to point to makes it less likely that the equity owners will have to disgorge payments they received and used to pay the Internal Revenue Service.  In addition, if a company is in financial distress, but has made tax distributions to its equity owners, check to see what the governance documents provide and assess the risk of a claim being made before recommending to the owners to file a bankruptcy case.