In a case that has broad implications for trustees and taxing authorities embroiled in preference avoidance actions, the Bankruptcy Court for the Western District of Missouri weighed in on the parameters of a trustee’s ability to avoid preferential sales and use tax payments under section 547 of the Bankruptcy Code.
Overdue Tax Payments
In Scully v. State of Arkansas Dep’t of Fin. & Admin. (In re Valley Food Servs., LLC), 389 B.R. 685 (Bankr. W.D. Mo. 2008), the debtor operated a distribution and trucking company that supplied various products to fast-food restaurants in several states. The debtor operated in Arkansas under the authority of a “Compensating Use Tax Permit” issued by the defendant taxing authority. Under Arkansas law, the debtor was required to pay certain taxes to the defendant for the goods it sold within the state.
At issue in Scully were the payment of two specific taxes (“Transfers”): (i) a $243,328 payment for overdue “Soft Drink Tax,” a tax levied on distributors of soft drink syrups or bottled drinks based on the volume of goods sold; and (ii) a $35,000 payment for overdue “Compensating Use Tax,” a tax levied on users of personal property purchased from vendors. As noted by the court, although the Compensating Use Tax was levied on purchasers of goods, the Arkansas tax code allowed vendors to collect and remit theCompensating Use Tax.
Starting in September 2005, the debtor failed to make any Soft Drink or Compensating Use Tax payments, which were required to be made on a monthly basis. As a result, on Dec. 21, 2005, the defendant issued a “Business Closure Order,” informing the debtor that the defendant would shut down the debtor’s business if the debtor did not pay the overdue sales and use taxes, in full, within five days of the Business Closure Order. On Dec. 23, 2005, the debtor complied with the Business Closure Order and made the demanded Transfers.
In February 2006, the debtors filed for chapter 11 bankruptcy protection and the case was converted to a chapter 7 case June 28, 2006. A chapter 7 trustee (“Trustee”) was appointed, and the Trustee timely commenced an adversary proceeding to recover the Transfers on the grounds that they were preferential transfers. In response to the Trustee’s motion for summary judgment on her complaint, the defendant argued that the Transfers were unavoidable pursuant of sections 547(c)(1) and (2) of the Code. The defendant further contended that the transferred funds were subject to a constructive trust in favor of the defendant and thus were not avoidable transfers of the debtor’s property under section 547(b) of the Code.
547(c) Preference Defenses
The bankruptcy court began its analysis by considering whether the preference defenses under section 547(c) of the Code applied to the Transfers at issue. As the court noted, normally section 547(c) preference defenses are addressed after a court has determined that a transfer is preferential. Here, the court decided to address the defenses first because it concluded that the undisputed facts established that neither of the Transfers could be sheltered from avoidance under section 547(c).
Section 547(c)(1) “shields from avoidance a transfer that was intended by the debtor and the creditor to be a contemporaneous exchange for new value and, in fact, was a substantially contemporaneous exchange.” In Scully, the defendant contended that “new value” was provided to the debtor in the form of “new credit” that allegedly was extended by way of the defendant’s agreement to refrain from taking legal actions to close down the debtor’s business and impose a lien on the goods sold to the debtor’s customers.
The court, however, rejected this notion, reasoning:
[A]ll [the defendant] did was to permit the Debtor to continue operating. There has been no suggestion or proof that the Defendant actually extended credit to the Debtor, by deferring monthly tax payments or otherwise. Courts have consistently held that refraining from exercising a preexisting right is not new value for purposes of § 547(c)(1), even if forbearance of that right enables the debtor to continue operating.
Accordingly, the court concluded that section 547(c)(1) did not support the defendant’s attempt to shield the Transfers from avoidance.
Next, the court turned to section 547(c)(2), which prevents a trustee from avoiding “a preferential transfer to the extent the transfer was for a debt incurred by the debtor in the ordinary course of the debtor’s business and made in the ordinary course of the debtor’s business or made according to ordinary business terms.” While the Transfers here may have been in payment of a debt incurred by the debtor in the ordinary course of its business, the court found that they were unquestionably not made in the ordinary course of the Debtor’s business or according to ordinary business terms.
As the court explained, “ordinary course of business” is not defined by the Code, and thus, a court must engage in a “peculiarly factual” analysis. Here, the court found that the Transfers were “textbook examples of transfers made outside the ordinary course of business.” First, the payments were made only after the defendant threatened to close down the debtor’s business if its tax obligations were not satisfied. The court also emphasized that there was no consistency between the massive amounts of the Transfers and prior tax payments. Therefore, the court found that section 547(c)(2) did not shield the Transfers from avoidance.
Defendant’s Trust Theory
Finally, the court addressed the defendant’s contention that the Transfers could not be avoided under section 547(b) because they were not transfers of the debtor’s property; rather, the defendant argued, they were transfers of the defendant’s property that the debtor held in trust for the defendant’s benefit.
Addressing application of the Soft Drink Tax, the court unhesitatingly rejected the defendant’s trust theory, noting the Soft Drink Tax was levied directly on the debtor as a distributor, with the amount based on the volume of syrup or bottled drinks sold. Looking to the Arkansas tax code itself, the court observed that there was nothing in the Soft Drink Tax provision or in the structure of the transaction giving rise to the tax that provided any grounds for the recognition of an express trust or the imposition of a constructive trust on the funds used to make the $243,328 Soft Drink Tax payment. Thus, the court concluded that the $243,328 Soft Drink Tax payment was an avoidable preference under section 547(b).
On the other hand, with regard to the $35,000 Compensating Use Tax, the court denied the Trustee’s motion for summary judgment. In its analysis, the court derived two applicable lessons from the Supreme Court case of Begier v. Internal Revenue Service, 496 U.S. 53 (1990).
First, the court found that “Begier does not stand for the proposition that specific trust language is necessary [in a taxing statute] to insulate a transfer from avoidance under section 547(b).” Accordingly, the court held that the absence of specific trust language in the Arkansas Compensating Use Tax statute did not entitle the Trustee to summary judgment. While the court remained “skeptical,” it nevertheless stated that the defendant should be given the chance to establish that the statute and the circumstances surrounding the $35,000 Compensating Use Tax payment gave rise to a constructive trust in favor of the defendant.
The second lesson from Begier, the court stated, is that the defendant faced a “significant hurdle” going forward. The court observed that unlike the federal tax statute at issue in Begier, the Compensating Use Tax contained no specific language imposing a trust on the “amount of tax” collected. Thus, the defendant would have to rely on Arkansas constructive trust law, which requires a party to trace, or “identify,” the trust res. In other words, the defendant would have to trace, by clear and convincing evidence, the $35,000 Compensating Use Tax payment to the taxes collected by payment pursuant to the Arkansas tax statute.
Still, the court concluded that the defendant should have this opportunity, and thus held that “there remains a material issue of fact precluding summary judgment as to whether the $35,000 was a transfer of an interest of the debtor in property or a transfer of trust property held by the Debtor for the benefit of the Defendant.”
Scully provides further ammunition to trustees in their battle to avoid preferential payments to taxing authorities, especially with regard to taxes directly levied on a debtor that are paid out of the ordinary course of business. The Scully court, however, has left open the possibility of imposing a constructive trust on certain tax proceeds. Of course, the burdens presented by the stringent tracing requirements under state constructive trust law may prove difficult.