Executive Summary
The Bankruptcy Code provides chapter 7 trustees with significant powers to liquidate and collect estate assets and pursue litigation claims, such as fraudulent transfer claims against third parties, all to increase the recoveries to creditors in a bankruptcy case. A trustee’s ability to pursue the IRS and other governmental units that may have a right to sovereign immunity has now been negatively impacted by the Supreme Court in a recent important decision. As a result, in those cases where such lawsuits against the IRS could have provided a meaningful recovery to the bankruptcy estate, general creditors with significant losses will, unfortunately, receive smaller distributions from the bankruptcy estate.
Supreme Court Decision
On March 26, 2025, the Supreme Court, in an 8-1 decision authored by Justice Ketanji Brown Jackson, resolved a split among various Circuit courts regarding the scope of the sovereign-immunity waiver in Section 106(a) of the Bankruptcy Code. United States v. Miller, No. 23-824, 2025 WL 906502 (U.S. Mar. 26, 2025).
The Supreme Court held that a chapter 7 trustee may not bring state law fraudulent transfer claims against the IRS or other governmental units, finding that Section 106(a) of the Bankruptcy Code does not waive the government’s sovereign immunity in this scenario. The Supreme Court noted this result is consistent with the concept, outside of bankruptcy law, that a creditor is not able to sue the federal government for recovery of fraudulent transfers.
As most state law fraudulent transfer statutes provide for a four (4) year lookback period, trustees or other estate representatives such as debtors in possession in chapter 11 cases may now only recover fraudulent transfers against the IRS and other governmental units under section 548(b) of the federal Bankruptcy Code, which notably only has a two (2) year lookback period.
Background
Miller involved a trustee seeking to recover roughly $145,000 of company funds that were misappropriated and transferred by two insiders of a defunct Utah-based transportation business to the IRS to cover the insiders’ personal tax liability to the IRS. As the transfer in this case took place three years before the company’s bankruptcy filing, the trustee could not rely on the two-year lookback period under Section 548(b) of the Bankruptcy Code to recover the transfer, and therefore, sought to recover the funds under Section 544(b) of the Bankruptcy Code, which allows the trustee to utilize other “applicable law” such as a state’s fraudulent transfer law. As Utah law applied to the transfer by the debtor in Miller, the trustee sought to apply Utah’s fraudulent transfer law, which has a four (4) year lookback period.
The IRS, though conceding the transfer was fraudulent, argued the fraudulent transfer claim was barred by sovereign immunity because section 544(b) only permits a trustee to recover transfers that are “voidable under applicable law by a creditor holding an unsecured claim”. The IRS argued that since a creditor outside of bankruptcy may not pursue the IRS directly based on sovereign immunity grounds, the trustee is similarly barred by sovereign immunity from pursuing the IRS under Section 544(b), coupled with the state law fraudulent transfer statute.
The lower courts in Miller, including the Tenth Circuit, disagreed with the IRS’s interpretation, finding instead that Section 106(a) waives the IRS’s right to assert a sovereign immunity defense to both the Section 544(b) claim itself and the underlying state law “nested” within the claim. The Tenth Circuit’s decision was consistent with the majority of Circuit courts that had previously addressed this legal issue.
The IRS appealed the Tenth Circuit’s decision and ultimately prevailed as the Supreme Court reversed the Tenth Circuit.
The Decision
In ruling in favor of the IRS and against the trustee, the Supreme Court began by discussing two well-established principles that guide courts’ interpretations of sovereign-immunity waivers. First, the Supreme Court noted that sovereign-immunity waivers are a “prerequisite to jurisdiction” that “do not create any new substantive rights or alter pre-existing ones.” This general principle is reaffirmed by Section 106(a)(5), which expressly states that “[n]othing in this section shall create any substantive claim for relief or cause of action not otherwise existing.” Second, according to the Court, sovereign-immunity waivers are to be “construed narrowly” with any ambiguities resolved in the government’s favor.
Beyond running afoul of these general principles, the Supreme Court also held the trustee’s interpretation of Section 106(a) was “untenable” as a matter of textual and statutory construction. While the trustee argued a broad reading of the sovereign-immunity waiver was required by Section 106(a)’s use of the phrase “with respect to” preceding a list of 58 Bankruptcy Code sections, the Supreme Court emphasized the importance of reading that clause in “context,” indicating that many of the 58 sections bear no relationship to sovereign immunity concerns. As the Supreme Court explained, “the sheer number of provisions [with unrelated subsections]…rebuts [the trustee’s] strained reading of Section 106(a).”
Finally, the Supreme Court noted the trustee’s interpretation of Section 106(a) contravenes the purpose of Sections 106(a) and 544(b). The House and Senate Reports accompanying the 1978 amendment which introduced Section 106 stated the provision was meant to “achieve approximately the same result that would prevail outside of bankruptcy.” Thus, according to the Court, adopting the trustee’s view would give the trustee rights above and beyond those a creditor outside of bankruptcy holds; a result the sections both expressly and impliedly reject.
Accordingly, for all these reasons, the Court reversed the Tenth Circuit and held that Section 106(a)’s sovereign-immunity waiver must be narrowly construed, eliminating the trustee’s right to pursue state law fraudulent transfer claims “nested” within Section 544(b) of the Code against the IRS and other governmental units.
Justice Gorsuch was the lone dissenter. In his view, after analyzing the various relevant statutory sections at issue, namely sections 106(a) and 544(b), together with Utah’s state law statute, the better reading is that sovereign immunity was waived under section 106(a), allowing a trustee to commence state law fraudulent transfer actions against the IRS.
Takeaways
The Supreme Court’s decision is likely to have a significant impact on a trustee’s ability to bring avoidance actions against the IRS, as well as other governmental units that are likely to assert that sovereign immunity applies. As noted, trustees and other estate representatives will now need to rely solely on section 548(b), which has a shorter two (2) year lookback period, and thus, any payments to the IRS outside this two (2) year period may no longer be recovered by a trustee against the IRS.
Further, the ruling could potentially lead insiders to effectuate transfers of company funds to the IRS to cover their personal tax obligations, knowing such funds, to the extent transferred more than two years earlier, could not be recovered against the IRS, either by creditors or a trustee under state law, in light of the IRS’s sovereign immunity. Importantly, nothing in the Supreme Court’s decision, however, deprives a trustee from pursuing insiders directly on account of fraudulent transfers made on their behalf to the IRS, thereby sidestepping the sovereign immunity issue (as the IRS would not be the target of the suit). As a practical matter, however, while a trustee pursuing an individual on a state law fraudulent transfer action may ultimately be successful in demonstrating liability on the part of the individual, the trustee may have difficulty collecting a judgment against such an individual.
Moreover, the Court did not address the applicability of Section 106(a) to suits brought under Section 544(a), which implicates, among other things, the avoidance of liens (including tax liens) which potentially could provide trustees with yet another avenue for possible recovery against the IRS.
Finally, only time will tell whether the Supreme Court’s narrow construction of the sovereign immunity waiver in this case will be extended by lower courts deciding sovereign immunity waivers to other provisions of the Bankruptcy Code.
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