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Liquidating Trustees and Tax Refunds in United States of America v. Edward P. Bond

PSZJ Case Alert
November 5, 2014

A recent Second Circuit decision creates a potential jurisdictional roadblock to the recovery of tax refunds by liquidating trustees. In USA v. Bond (In re PT-1 Communications Inc.), No. 12-4803 (2d. Cir. August 13, 2014), a liquidating trust was created pursuant to the debtors’ liquidating plan. The liquidating trustee pursued a federal income tax refund in the bankruptcy court pursuant to section 505 of the Bankruptcy Code, filing a counterclaim to an IRS administrative expense claim and objecting to the IRS claim. The bankruptcy court ruled for the liquidating trustee, disallowing the IRS claim and granting summary judgment for a $3.8 million refund on the counterclaim. The bankruptcy court also held that the Plan precluded the IRS from setting off the refund against its claim.

On appeal, the IRS argued that the liquidating trustee was not entitled to employ section 505 and the IRS therefore enjoyed sovereign immunity, which “(i) foreclosed bankruptcy court jurisdiction over the refund counterclaim, and (ii) prevented the [IRS] from being bound by the anti-setoff and anti-recoupment provisions of the Plan.” While the district court vacated the holding that the Plan precluded setoff, it otherwise upheld the bankruptcy court’s decision, particularly its exercise of jurisdiction over the dispute, holding that section 505(a)”does not limit the bankruptcy court’s ability to adjudicate tax disputes to only those brought by bankruptcy trustees.”

On further appeal, however, the Second Circuit held that sovereign immunity precluded bankruptcy court jurisdiction because a liquidating trustee is not among those who may employ section 505 to file a tax refund claim in bankruptcy court. Although section 505 is among the provisions that “trump” sovereign immunity under section 106(a)(1) of the Bankruptcy Code, section 505(a)(2) provides that only a “trustee” can use it, and the Second Circuit held that only a bankruptcy trustee or debtor in possession may qualify as a “trustee.” The court of appeal further held that a plan provision cannot cure this jurisdictional issue.

The practical import is that the debtor or bankruptcy trustee should commence tax refund claims in the bankruptcy court prior to plan confirmation (as the court observed that nothing would prevent the liquidating trustee from assuming control over a properly filed tax refund claim). If they have not done so, then the liquidating trustee may pursue the refund in the federal district court.

Please contact Andy Caine for more information on liquidating trustees.