In a case addressing an issue of apparent first impression, the United States Court of Appeals for the Eleventh Circuit held last week that a corporation’s subchapter S election constituted reasonably equivalent value for its obligation to pay a dividend, thus requiring dismissal of a suit to avoid the payment of a dividend as a constructively fraudulent transfer. Crumpton v. Stephens (In re Northlake Foods).¹

Background

The debtor (Northlake) was a Georgia corporation that owned approximately 150 Waffle House restaurants. Northlake’s shareholder agreement, which was executed in 1991, contained a provision requiring that if Northlake’s income ever became taxable to a shareholder rather than the corporation, the corporation was required to pay a dividend in an amount sufficient to permit the shareholder to pay the taxes attributable to the corporation’s income.

In 2005, Northlake made the subchapter S election, thus requiring that the shareholders rather than the corporation pay income taxes attributable to the corporation’s income. Richard Stephens, a shareholder of Northlake, had approximately $94,000 of personal income tax attributable to Northlake’s 2005 income. Accordingly, consistent with the requirement in its shareholders’ agreement, Northlake’s board of directors passed a resolution in 2006 requiring that Northlake make a cash distribution to Stephens in the amount of approximately $94,000. Northlake made a cash payment to Stephens in 2006 in accordance with the board’s resolution.

Northlake filed a Chapter 11 petition in 2008 (within two years of payment of the dividend). David Crumpton, who was later appointed bankruptcy trustee, sued Stephens in 2010 seeking to avoid and recover the 2006 tax dividend as a constructively fraudulent transfer. The bankruptcy court dismissed the complaint, concluding that Northlake received reasonably equivalent value for payment of the dividend “by virtue of the Debtor’s Subchapter S election for federal income tax purposes.” The trustee then amended its complaint to assert a claim against Stephens for recovery of an improper dividend paid in violation of the Georgia corporation statute, which prohibits the payment of a dividend at a time that the corporation is insolvent. The bankruptcy court dismissed this claim against Stephens (who was the recipient of the dividend but not a director of Northlake) on the basis that the Georgia statute permits recovery of an improper dividend only against directors that authorize the improper dividend rather than the shareholder that receives the improper dividend.

The only issue on appeal was whether “Northlake’s S-corporation election constituted reasonably equivalent value for the 2006 Transfer.” The district court and the Eleventh Circuit both affirmed the bankruptcy court’s holding that Northlake had received reasonably equivalent value for the dividend, thus denying recovery of the dividend as a fraudulent transfer.

The Law and the Eleventh Circuit’s Reasoning

Fraudulent transfer law generally permits recovery of transfers made within two years of the date of the bankruptcy filing for less than reasonably equivalent value if the debtor was insolvent at the time of or as a result of the transfer. Section 548 of the Bankruptcy Code defines “value” to include “satisfaction or securing of a present or antecedent debt of the debtor.”

In concluding that the making of the S-election constituted reasonably equivalent value for the payment of the dividend to Stephens, the Eleventh Circuit reasoned:

In 1991, Northlake approached Stephens with a Shareholders Agreement that requested his consent to pay a share of Northlake’s taxes if it ever elected to be treated as an S corporation. In exchange for taking on this tax liability, the Shareholders Agreement obligated Northlake to reimburse Stephens for the personal income tax liability he incurred that was attributable to the tax liability of Northlake. This agreement benefitted Northlake because it secured shareholder consent for Northlake to shift to S-corporation status whenever it determined it was advantageous to do so. Not only did the Shareholders Agreement grant Northlake greater flexibility to shift its tax status, when it did decide to shift status, Northlake enjoyed the added benefit of freeing up cash that otherwise would have been dedicated to paying Northlake’s tax liability. Though Northlake incurred a financial obligation to its shareholders under the agreement, it did not need to satisfy that obligation until a year after the shareholders had incurred Northlake’s tax liability. This had the effect of providing Northlake with another valuable benefit: time.

Interestingly, the Eleventh Circuit held that the bankruptcy court had properly dismissed the trustee’s complaint without an evidentiary hearing because the complaint provided “no grounds to conclude” a lack of reasonably equivalent value:

These benefits are evident from the face of the complaint and the exhibits attached to it. Because the complaint contains no allegations indicating why these benefits do not constitute a reasonably equivalent exchange for the 2006 Transfer, we have no grounds to conclude they do not.

Analysis and Practice Tip

The result in Northlake may have been different if the debtor was not obligated by its shareholder agreement to pay tax dividends as this obligation constituted “value” for purposes of the analysis. Although the Eleventh Circuit did not make the distinction, it is interesting that the Eleventh Circuit chose not to discuss the myriad of decision uniformly holding that the pre-bankruptcy revocation of an S-election constitutes a voidable fraudulent transfer², the post-petition revocation of an S-election constitutes a voidable violation of the automatic stay³ and the decision to carry net operating losses forward but not backwards⁴ constitutes a voidable fraudulent transfer. The facts in these lines of cases did not involve long-standing agreements on the treatment of tax attributes and likely remain good law in light of the Eleventh Circuit’s relatively narrow, fact-specific analysis in Northlake.

One practice pointer that can be derived from Northlake is that the plaintiff in any fraudulent transfer action should provide detail in the complaint why the value received by the debtor is not reasonably equivalent in value to the property transferred, or risk a dismissal of the complaint on the pleadings.

[1] 2013 WL 1859118 (May 6, 2013).

[2] E.g., Parker v. Saunders (In re Bakersfield Westar, Inc.), 226 B.R. 227 (B.A.P. 9^th Cir. 1998); In re Trans-Lines West, Inc., 203 B.R. 653 (Bankr. E.D. Tenn. 1996).

[3] E.g., The Majestic Star Casino v. Barden Development, 466 B.R. 666 (Bankr. D. Del. 2012) (voiding non-debtor parent’s post-petition revocation of its S corporation status which had the effect of terminating debtor’s qualified S corporation status (QSub)).

[4] E.g., U.S. v. Sims (In re Feiler), 230 B.R. 164 (B.A.P. 9^th Cir. 1999, aff’d 218 F.3d 948 (9^th Cir. 2000); Gibson v. U.S. (In re Russell), 927 F.2d 413 (8^th Cir. 1991); U.S. v. Kapila, 402 B.R. 56 (S.D. Fla. 2008), aff’g 386 B.R. 361 (Bankr. S.D. Fla. 2008).