Tax Liens Allowed Chapter 7 Trustee to Avoid Disclaimed Inheritance Under Federal Law

(Parker Tax Publishing April 2023)

A bankruptcy court held that a chapter 7 trustee could avoid a debtor's disclaimed inheritance as a fraudulent transfer under the Federal Debt Collection Procedures Act (FDCPA) because the IRS was an unsecured creditor in the bankruptcy. The court found that, since the IRS could have avoided the disclaimer under the FDCPA, the trustee was allowed to step into the shoes of the IRS to avoid the transfer and recover the proceeds for the benefit of the debtor's creditors. In re Spencer, 2023 PTC 62 (Bankr. S.D. Ill. 2023).

Background

In 1995, John Spencer's parents established an irrevocable trust for the benefit of their descendants. The trust provided that, upon the death of the last grantor, the assets of the trust, consisting of $1,500,000 of life insurance proceeds, were to be divided equally among the Spencers' four children (John and his three sisters). In January of 2019, John's father died, and the trustee distributed $375,000 to each of John's three sisters. However, John disclaimed his $375,000 inheritance. The trustee therefore distributed John's share of the funds in equal amounts to his seven children under the terms of the trust.

John filed for chapter 7 bankruptcy in July of 2020. Among John's creditors was the IRS, which had filed liens against John for unpaid taxes. In 2022, the bankruptcy trustee filed an adversary complaint seeking to avoid John's disclaimer as a fraudulent transfer under Section 544(b) of the Bankruptcy Code and 28 U.S.C. Section 3304 (i.e., the Federal Debt Collection Procedures Act (FDCPA)).

Under 11 U.S.C. Section 544(b)(1), a bankruptcy trustee generally may avoid a transfer of the debtor of property if the transfer is voidable under "applicable law" by an unsecured creditor. Thus, Section 544(b)(1) permits the trustee to "step into the shoes" of an actual unsecured creditor to recover transfers that the creditor would otherwise have been able to recover but for the filing of the bankruptcy petition. The trustee asserted in the adversary complaint that, because the IRS was one of John's unsecured creditors, the FDCPA was the "applicable law" and therefore, the trustee could step into the shoes of the IRS and avoid John's disclaimer under the FDCPA.

John and his children filed a motion to dismiss the trustee's adversary complaint. They argued that the FDCPA is inapplicable to avoidance actions brought by a bankruptcy trustee under 11 U.S.C. Section 544(b)(1). They also contended that, because John disclaimed his interest in the trust proceeds under Illinois law, he never possessed an interest in property or an asset that could be transferred under the FDCPA. According to John and his children, because Section 544(b)(1) is contained within the Bankruptcy Code, the word "property" should be interpreted as it would in bankruptcy, i.e., by reference to state law. Under Illinois law, upon execution of a disclaimer the property in question passes as if the disclaimant had predeceased the decedent and the disclaimer relates back to the date of the decedent's death "for all purposes" (the relation-back provision). In In re Atchison, 925 F.3d 209 (7th Cir. 1991), a debtor filed a chapter 7 petition less than three months after she disclaimed an inheritance, causing the property to pass to the debtor's children. The Seventh Circuit rejected the chapter 7 trustee's attempt to avoid the disclaimer after finding that the "relation back" provision of the Illinois statute eliminated any interest that the debtor held at the time of the disclaimer, and therefore, there could be no transfer.

Analysis

The bankruptcy court denied the motion to dismiss and the trustee was permitted to avoid John's disclaimer under the FDCPA.

The bankruptcy court noted that there is a split of authority as to whether the FDCPA constitutes "applicable law" for purposes of Section 544(b)(1) of the Bankruptcy Code, but most courts say that it does. Analyzing the statutory language, the court found that Section 544(b) is quite broad. Rather than restricting the trustee to avoidance actions under "state law," Section 544(b)(1) uses the term "applicable law." The court noted that the only limiting factor imposed by Section 544(b)(1) is that the creditor in whose shoes the trustee steps must have the ability to avoid the transfer under the law in question. The court also observed that Section 544(b) does not restrict which of the debtor's creditors the trustee chooses as the "triggering creditor" to avoid the transfer, so long as such creditor holds a claim that is allowable under Section 502, or not allowable only under Section 502(e) of the Bankruptcy Code.

The court also rejected the argument that John never possessed an interest in the disclaimed property. The court reasoned that, under the Supremacy Clause of the Constitution as well as an express preemption cause in the FDCPA, the definitions of "transfer" and "asset" provided in the FDCPA took precedence over the definitions under Illinois law. Under the FDCPA, the definition of "property" is defined broadly to include any present or future interest in property, including property held in trust. In the court's view, the FDCPA was clearly intended to reach "any" interest in property that a debtor might have. Since it was undisputed that, as a beneficiary under the trust, John had a vested right to receive a distribution of his share of the trust, the court concluded that under the FDCPA he held either a present or future interest in property held in trust, which he disposed of by executing the disclaimer.

Observation: The court noted that the issue in this case was one of first impression before it and remarked that permitting the trustee to proceed under the FDCPA may seem like a departure from established law. However, the court observed that the fact that trustees rarely invoke the FDCPA did not make it improper. In the court's view, it was highly likely that the dearth of cases on this issue was because trustees are unaware that this avoidance provision exists, not because they don't believe it is applicable. Further, the court said that because Section 3304 of the FDCPA is so similar to the Uniform Fraudulent Transfer Act, there is likely little reason for the trustee to use it unless they are trying to take advantage of its longer lookback period (six years as opposed to four years under most state statutes) or, as in this case, attempting to reach an asset that would be beyond their grasp under state law.

For a discussion of chapter 7 bankruptcy, see Parker Tax ¶16,130.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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