We have not previously done a post on the insolvency statute. Our failure to cover this topic cannot be the source of the problem for Randy Read in the case, recently decided against him, which was brought by the United States. Perhaps someone reading this post will be saved from the personal liability that has now befallen Mr. Read.
The insolvency statute is not found in title 26 with the rest of the internal revenue laws and is not found in title 11 with the bankruptcy laws but rests in title 31 at section 3713. This statute can trace its roots back to the very beginning of the United States and was one of the first laws passed when we formed as a nation. It can trace its roots back further into English common law and the statement “the King’s debtor dying, the King comes first.” The insolvency statute does not apply only to tax debts but to all debts owed to the United States. The application of the insolvency statute to tax debts, in fact, took a nasty turn for the IRS almost 20 years ago in a Supreme Court case named Romani.
Before the Supreme Court decision in Romani, the IRS took the position that it could defeat other creditors to whom it might otherwise lose if the party over whom the IRS was fighting for scraps to satisfy its liability was insolvent and not in bankruptcy. The insolvency statute does not apply in bankruptcy cases which provide a more specific regime for resolving the priority of creditors. The application of the insolvency statute, at least in tax cases, comes up most frequently in the circumstances of insolvent decedent’s estates. In Romani, a judgment creditor properly recorded a judgment before the IRS recorded its notice of federal tax lien. In the absence of the application of the insolvency statute, the judgment creditor would defeat the IRS in a fight for the taxpayer’s assets because of 6323(a) which gives priority to judgment creditors who record prior to the filing of the notice of federal tax lien.
Mr. Romani passed away. His estate contained an asset of some value but not enough value to satisfy both the judgment lien and the tax lien. The IRS argued that it defeated the judgment lien based on the insolvency statute even though it would lose under 6323(a). The judgment creditor did not like that result and the case worked its way to the Supreme Court which found that the Federal Tax Lien Act of 1966 establishing the currently applicable lien law in the internal revenue code created a more specific statement of Congressional intent than the general provision of the insolvency statute. Construing the statutes, the Court found that the specific should take precedence over the general and the IRS loses when competing against a judgment lien creditor that would defeat it under the statute scheme of 6323 specifically designed to decide priority fights between the tax lien and other creditors. The Romani decision certainly disappointed the IRS but it does not completely eliminate the insolvency statute from the federal tax world as Mr. Read found out to his sorrow.
In 1999 Mr. Read established a trust for his children with himself as trustee. His wife had some stock options with which the trust was settled. The trust had a value of over $700,000 in 1999. In 2000 the trust filed a request for extension to file its return indicating a liability of over $121,000. Mr. Read was aware of this liability. By June 2001, at which time the trust still owed the taxes, the value of the trust had dropped to about $163,000. Between July 5 and July 30, 2001, Mr. Read made four payments totaling $25,000 for home improvements. These seemed to be improvements on his home and not the home of one of the children beneficiaries. The opinion does not state whether the repairs specifically benefited the children by creating a home theater. I got the impression Mr. Read was using the trust for personal rather than trust reasons but that may be an inappropriate assumption. He then disbursed another $25,000 on July 31 to himself bringing the value of the trust to $108,000. From that time until January 2010, the value of the trust never exceeded the amount owed to the IRS which remained unpaid throughout this period. Market gains during this period allowed him to disburse almost $200,000 from the trust which was used for renovating his house, investing in real estate (I assume investing by him and not the children), paying for private preschool education and summer camp. He wrote about $80,000 in checks directly to himself which is not a good fact for him in this situation.
The opinion does not state what efforts the IRS made to collect the tax during this decade long use of trust funds to primarily benefit Mr. Read while not paying the taxes of the trust, but at some point the IRS must have tired of corresponding with the trust. Like many of my clients, Mr. Read may have concluded that the IRS primarily exists to send correspondence. Because it sends so much correspondence before it starts taking people’s stuff, many people seem to think they can ignore the correspondence and one day the IRS will just go away. So, I imagine that one day a revenue officer in Connecticut sent a suit referral to the District Counsel’s office in Hartford, which, in turn, sent a suit referral letter to the Department of Justice Tax Division, in Washington, D.C., which in turn brought suit against Mr. Read in Federal District Court citing to the insolvency statute and seeking to hold him personally liable for the unpaid taxes of the trust allegedly established for his children. I imagine Mr. Read was surprised when the suit was served on him but maybe not. After filing the suit, the government moved for summary judgment.
The Court started with the statutory language of 31 U.S.C. 3713(a)(1)(A)(i) by saying “an insolvent person who is indebted to the United States must first pay the claims of the United States before voluntarily assigning property to others.” It followed this statement of the general rule that applies to insolvent debtors with a quote from 31 U.S.C. 3713(b) concerning those responsible for the insolvent debtors: “A representative of [an insolvent] person or an [insolvent] estate (except a trustee acting under [the Bankruptcy Code]) paying any part of a debt of the person or estate before paying a claim of the Government is liable to the extent of the payment for unpaid claims of the Government.” The court found that Mr. Read would have personal liability under the insolvency statute if, as trustee, he distributed trust assets while the trust was insolvent and he knew or had notice of the debt due to the United States. The government put on the evidence of the liability and his knowledge of the liability and his payments from the trust. Mr. Read did not refute the evidence of the government. The court found that he owed the full amount of the outstanding federal tax debt, which now stands at over $213,000 because of interest and penalty accruals over the years. He made total distributions of over $197,000. He has since made payments of about $22,000, so it entered a judgment against him for $175,042.16.
The government did not stop at that point but also requested prejudgment interest. This type of interest is not routinely awarded and the district court has a fair amount of discretion in deciding whether to award it. The court found that most insolvency statute cases decline to award prejudgment interest. Here, the court found such interest appropriate citing several factors: 1) the need to fully compensate the wronged party; and 2) considerations of fairness because he was self-dealing. In many cases in which individuals get hit with personal liability, they make a poor business decision with assets of an estate or trust or they distribute to beneficiaries when they should have paid taxes. This type of action can trigger the liability but the individuals held liable are frequently sympathetic and often are serving in a fiduciary capacity for the first time. Here, Mr. Read evoked little or no sympathy. Whether the IRS ultimately gets paid is another question but Mr. Read now has a personal judgment against him that will stay there for a very long time.