The Bottom Line:

Often times, tax planning can be an important part of assessing an estate’s available assets and preserving the value of such assets for the benefit of the reorganized debtor and its creditors. A recent decision analyzed the scope of tax sharing agreements as part of a bankruptcy estate. In Zucker v. FDIC (In re BankUnited Fin. Corp.), No. 12-11392, 2013 U.S. App. LEXIS 16896 (11th Cir. Aug. 15, 2013), the Eleventh Circuit Court of Appeals found that tax refunds received by a parent corporation which, pursuant to a tax sharing agreement (a “TSA”) were to be distributed by its subsidiary bank to other members of the consolidated tax group, did not constitute assets of the debtor-parent’s bankruptcy estate. The court held that in the absence of express language in the TSA creating a debtor-creditor relationship between the parent and subsidiaries, a trust relationship was created, and the parent corporation merely held the assets in trust for the benefit of its subsidiary bank. The decision is especially interesting when compared with the Second Circuit Court of Appeals’ decision in Superintendent of Ins. v. Ochs (In re First Cent. Fin. Corp.), 377 F.3d 209 (2d Cir. 2004), which reached the opposite result in a case also involving the interpretation of a TSA between a debtor-parent corporation and its subsidiaries. 

Before delving into the facts of the cases, let’s review the pertinent background on tax sharing/allocation agreements. Internal Revenue Service (“IRS”) rules permit a parent corporation to file one consolidated federal income tax return on behalf of itself and all of its subsidiary corporations under certain conditions. Each entity in the consolidated group calculates its taxable income or loss as if it were a “stand-alone” taxpayer outside of the group, and then the income or deductions (including net operating losses (“NOLs”) or other tax credits) of each entity are combined to determine the consolidated group’s federal income tax liability. The parent acts as an agent for the consolidated group, filing a single consolidated tax return for the group. If the losses of any entities were not completely absorbed within the current tax year, the consolidated group may be entitled to carry back or carry forward NOLs to offset taxable income in certain specified prior or future years. The parent, as agent for the consolidated group, makes any necessary payments or receives any refunds on behalf of the consolidated group. 

Federal law does not specify how tax liabilities, tax savings, or tax refunds should be allocated between the entities in a consolidated group. Parent and subsidiary entities may provide for such allocation by contract, and this is commonly achieved by the use of tax sharing agreements or tax allocation agreements. However, if a member of a consolidated group files for bankruptcy, disputes often arise between debtors (and their creditors) as to whom any tax refunds belong. That is precisely what occurred in the BankUnited and First Central Financial cases discussed herein. 

Zucker v. FDIC (In re BankUnited Fin. Corp.), No. 12-11392, 2013 U.S. App. LEXIS 16896 (11th Cir. Aug. 15, 2013) 

In 1997, BankUnited Financial Corporation (the “Holding Company”) and one of its subsidiaries BankUnited FSB (the “Bank”), both members of a consolidated group, entered into a TSA to govern the allocation of tax payments and benefits among the members of the consolidated group. 2013 U.S. App. LEXIS 16896, at *1-2. The TSA provided that the Holding Company would file the federal income tax return for the consolidated group but the Bank would pay all the taxes for the consolidated group. Id. at *2-3. The TSA also dictated that within thirty days after the filing of the return and payment of the taxes, members of the consolidated group were to reimburse the Bank for their share of the taxes paid, and the Bank would pay the consolidated group members any tax refund it expects or was entitled to receive. Id. 

On May 21, 2009, the Bank was closed and the Federal Deposit Insurance Corporation (“FDIC”) was appointed as the Bank’s receiver. Id. at *4. The next day, the Holding Company filed for Chapter 11 bankruptcy. Id. After the filing, the Holding Company and the Bank requested refunds from the IRS for fiscal years 2007 and 2008, respectively totaling approximately $5.5 million and $42.5 million. Id. The IRS granted the request and sent the refunds to the Holding Company. Id. The Holding Company did not forward the refunds to the FDIC for distribution as required by the TSA, but retained the funds, claiming they were assets of the bankruptcy estate. Id. The FDIC filed a claim in the bankruptcy case, asserting that it was entitled to the refunds and was required to distribute them under the TSA. Id. The parties stipulated and the bankruptcy court ordered that the funds be held in escrow pending the court’s decision as to whether the refunds were property of the Holding Company’s estate. Id. 

The bankruptcy court granted summary judgment in favor of the Holding Company, and found that the refunds were assets of the Holding Company’s estate, but that the Bank would have a general unsecured claim against the Holding Company under the TSA. Id. at *6. The Bank appealed. Id. at *7. 

On appeal, the Eleventh Circuit Court of Appeals considered whether the bankruptcy court erred in declaring the refunds assets of the Holding Company’s estate. Id. The Eleventh Circuit considered the question “a matter of contract interpretation,” id. at *7. Analyzing the language of the TSA, the Eleventh Circuit noted that the TSA, governed by Delaware law, contained ambiguous language regarding when the Holding Company was required to forward refunds to the Bank and whether the Holding Company owned the refunds before sending them on to the Bank. Id. at *15. In such a situation, Delaware law allowed the court to infer the parties’ intent. Id. at *15-16. The appeals court held that even though the TSA did not contain an express provision requiring the Holding Company to forward the refunds to the Bank on receipt, that was the parties’ intent. Id. at *18. 

Additionally, the Eleventh Circuit inferred from the absence of language in the TSA creating a debtor-creditor relationship (e.g. “words from which terms of indebtedness could be inferred”), id. at *18-20, that the parties intended that, when the Holding Company received the refunds from the IRS, it would hold the funds in trust or escrow for the benefit of the Bank, who would forward them to other members of the consolidated group in accordance with the TSA. Id. at *20-21. Accordingly, the appeals court reversed the decision below and directed the Holding Company to forward the escrowed funds to the FDIC, as receiver for the Bank. Id. at *21. 

Superintendent of Ins. v. Ochs (In re First Cent. Fin. Corp.), 377 F.3d 209 (2d Cir. 2004) 

In the case In re First Central Financial Corp., First Central Financial Corporation (“Parent”) was the parent corporation of regulated insurance company First Central Insurance Company (“FCIC”). In the 1980s, the parties entered into a TSA which dictated how tax payments and benefits were to be allocated between the parties. 377 F.3d at 211. The TSA provided that if any tax refunds were generated, FCIC was entitled to receive at least the amount it could have claimed had it filed individual returns and claimed the refunds on a “stand-alone” basis. Id. 

For years, Parent filed consolidated tax returns on behalf of itself, FCIC and another wholly-owned subsidiary. In 1994 and 1995, FCIC was the only member of the consolidated group that earned taxable income, and paid the group’s entire tax liability for those years. Id. In subsequent years, FCIC and the other group members suffered losses. In 1996 and 1997, Parent applied for and received tax refunds paid by the group in prior years. Id. The IRS sent the refunds to Parent, which then paid them to FCIC pursuant to the Agreement. Id. Then, in January 1998, subsidiary FCIC became insolvent and the New York State Department of Insurance placed FCIC in rehabilitation proceedings. Id. In March 1998, Parent filed for bankruptcy. Id. 

In December 1998, Parent’s Chapter 7 trustee applied to the IRS for a refund of the remainder of the taxes the consolidated group paid in 1994 and 1995. Id. The IRS sent Parent’s chapter 7 trustee a refund of approximately $2.5 million. Id. The chapter 7 trustee did not turn over any portion of the refund to FCIC as required by the TSA and as was done in prior years, asserting that the refunds were property of Parent’s bankruptcy estate. Id. The Superintendent of Insurance filed an adversary proceeding in the bankruptcy court seeking a declaration that the refund had been held by Parent in trust for FCIC, and was not property of Parent’s bankruptcy estate. Id. 

The bankruptcy court examined the terms of the TSA, and noted that it did not include: (i) express language creating an agency or trust relationship; (ii) express language requiring escrow of the tax refund for the benefit of FCIC; or (iii) restrictions on how Parent could use the refund prior to paying FCIC. Superintendent of Ins. v. First Cent. Fin. Corp. (In re First Cent. Fin. Corp.), 269 B.R. 481, 491-95 (Bankr. E.D.N.Y. 2001). Because the TSA did not expressly create a trust for FCIC’s benefit, did not require Parent to escrow the tax refund for FCIC, and did not restrict Parent’s use of the refund before paying FCIC, the bankruptcy court concluded that the TSA did not give rise to a trust or create an agency relationship. Id. at 494-98. Rather, the TSA merely created a debtor-creditor relationship. Id. 

Additionally, the bankruptcy court found that the imposition of a constructive trust was not warranted under New York law because the Parent-FCIC relationship was governed by the TSA, and in New York, constructive trusts are generally only imposed to rectify fraud (not to enforce parties’ intentions). Id. at 499-501. Therefore, the bankruptcy court held that FCIC was required to pursue its claim for any amounts owed under the TSA as a general unsecured creditor of Parent’s estate. Id.at 502. 

On appeal, the Superintendent of Insurance argued that, even if the TSA did not create an express trust, and even if the refund was property of Parent’s bankruptcy estate, that the facts warranted the imposition of a constructive trust on FCIC’s behalf. 377 F.3d at 212. The district court and the Second Circuit Court of Appeals both affirmed the bankruptcy court decision. The Second Circuit held that: (i) Parent was not unjustly enriched by the retention of the refund, (ii) a constructive trust was not an appropriate remedy where the rights of the parties were governed by the TSA, id. at 212-14, and (iii) the trustee, by retaining the refunds, was merely fulfilling his duty to marshal and conserve estate assets for distribution to creditors. Id. at 216-17. 

Why the Case is Interesting: 

The In re BankUnited Financial Corporation case is itself important because it is a precedential decision from a circuit court of appeals, and one of only a relative few decisions on the interpretation of TSAs in bankruptcy. The In re BankUnited Financial Corporation case also merits comparison with the In re First Central Financial Corporation case because each court interpreted TSAs and reached different results. Both courts examined the language of the relevant TSA to discern the parties’ intent and determine ownership of tax refunds. However, in the former case, the court held that the absence of express language defining the parties’ relationship by default created a trust relationship. In the latter case, the court held that the absence of express language creating a trust, and in the presence of language suggesting a created a debtor-creditor relationship, that the court would not impose a constructive trust. The reason for the divergent outcomes in the decisions is not clear on the face of the opinions, but might be attributed to the Second Circuit’s reliance on applicable state law governing constructive trusts which the Eleventh Circuit did not address. 

These cases demonstrate why affiliates who are considering entering into, or who have entered into, TSAs should consult with counsel to analyze applicable state and federal law to determine how such agreements should be drafted to best reflect the parties’ intent in the event of a bankruptcy.