In its recent decision in Rodriguez v. Federal Deposit Insurance Corp., No. 18–1269 (Sup. Ct. Feb. 25, 2020), the Supreme Court held that federal courts may not apply the federal common law “Bob Richards Rule” to determine who owns a tax refund when a parent holding company files a tax return but a subsidiary generated the losses giving rise to the refund. Instead, the court should look to applicable state law.
General Legal Background
For U.S. federal income tax purposes, a corporate parent and its wholly owned corporate subsidiaries generally may elect to file consolidated federal tax returns. A consolidated tax return allows the group (the parent and its subsidiaries) to offset the income and gain of some group members by losses and deductions of other group members, thus paying tax only on the net income. When the group’s consolidated return is filed, the parent acts as the agent for the entire group in dealing with the IRS — including by filing returns and receiving refunds, if any. The U.S. federal income tax law does not dictate how the group’s tax liabilities or refunds are to be allocated and shared among the group members. To address this, consolidated group members frequently enter into a “tax allocation agreement” to deal with the allocation of tax items among the group members, including tax refunds.
In the absence of a tax allocation agreement, courts normally turn to state law to ascertain how to distribute the refund among the group members. However, some federal courts have crafted their own federal common law rule (the Bob Richards Rule). See In re Bob Richards Chrysler-Plymouth Corp., 473 F. 2d 262 (9th Cir. 1973). The Bob Richards Rule, as originally conceived, provided that absent a tax allocation agreement, the tax refund belongs to the group member whose losses resulted in the refund. Some courts have expanded the rule to look to the tax allocation agreement only if it unambiguously provides for a different result. Not all circuits, however, follow the Bob Richards Rule. The Sixth Circuit, for example, previously observed that “federal common law constitutes an unusual exercise of lawmaking which should be indulged . . . only when there is a significant conflict between some federal policy or interest and the use of state law.” FDIC v. AmFin Financial Corp., 757 F. 3d 530, 535 (6th Cir. 2014). The Sixth Circuit’s view is that courts employing the Bob Richards Rule have bypassed this threshold question. Id. at 536.
In Rodriguez v. Federal Deposit Insurance Corp., United Western Bank suffered significant losses and entered receivership with the Federal Deposit Insurance Corporation (FDIC) serving as receiver. Shortly thereafter, its parent, United Western Bancorp, Inc., was forced into bankruptcy. The IRS issued the consolidated group a $4 million tax refund, which was generated from the subsidiary’s losses. The FDIC and the parent corporation’s bankruptcy trustee, Simon Rodriguez, each sought to claim it. Following rulings of the bankruptcy and district courts, the case eventually reached the Tenth Circuit Court of Appeals. While a tax allocation agreement existed, the Tenth Circuit concluded that the agreement was ambiguous on the treatment of the refund (and under the agreement any ambiguity was to be decided in favor of the bank), and applied the Bob Richards Rule in holding that the refund belonged to United Western Bank because that subsidiary generated the losses that led to the refund.
The Supreme Court vacated and remanded. Agreeing with, among others, the Sixth Circuit, the Supreme Court held that the Bob Richards Rule is not a legitimate exercise of federal common lawmaking because it is not “necessary to protect uniquely federal interests.” The Court stated that federal courts that apply and extend the Bob Richards Rule have not shown any unique federal interest to be protected in determining how a consolidated group’s corporate tax refund should be shared by the members of the group, and should thus turn to applicable state law to adjudicate such disputes. While noting that “[s]ome, maybe many, cases will come out the same way under state law or Bob Richards,” the Supreme Court determined only the threshold issue of what legal standard should apply (i.e., a state, not a federal, one), and remanded to the lower court to determine ultimate ownership of the tax refund.
Implications of the Decision
The Rodriguez decision — a unanimous one — is perhaps not surprising as a matter of bankruptcy law. As the Court notes, it has long been the law that “the determination of property rights in the assets of a bankrupt’s estate [is generally left to] state law.” Moreover, the Court, both within and without the bankruptcy context, has repeatedly noted the “modest role” of judicial lawmaking in the form of federal common law. Nevertheless, the decision supplies important certainty in an area in which the lower courts had previously been divided.
From a practical standpoint, this decision will likely impact how tax refunds are allocated in the absence of a tax allocation agreement and how tax allocation agreements are drafted and enforced. However, because post-2017 federal net operating losses can no longer be carried back to prior years, the number of disputes over refunds likely will decline over time. Moreover, while courts must now apply state law, state law does not always provide a clear answer as to how to allocate a refund. In addition, it is important to note that seemingly unambiguous provisions in a tax allocation agreement entitling the loss subsidiary to the refund have led to contentious litigation as to whether the parent holds the refund as agent of the subsidiary, or whether the subsidiary is an unsecured creditor of the parent in the parent’s bankruptcy. That question was the very ambiguity that the Tenth Circuit found in interpreting the tax allocation agreement at issue. The Supreme Court’s Rodriguez decision sheds no light on these important issues, which will no doubt continue to develop in the lower courts