Recently, a corporation decided to proclaim bankruptcy as a tax shelter but the bankruptcy judge called the bankrupcy a sham and dismissed the bankruptcy proceeding. Three Seventh Circuit judges just affirmed that decision on appeal clarifying that bankruptcy was not created by Congress as a way to get out of paying taxes. See In re South Beach Securities, Inc., Seventh Cir. No. 90-3079 (May 19, 2010). This is just another example of a company trying to commit government fraud.
Posner notes that it was the US trustee, not the IRS, that objected to a bankruptcy that was phony and only for the purpose of evading taxes. The Seventh Circuit clearly thought it was important for someone to watch out for the interests of the federal fisc in these kinds of cases.
The statute is a mishmash but the view that the U.S. Trustee can be a party in interest makes better sense, as this case illustrates; we’ll see that the case really needed a watchdog, and we cannot see what would be gained by everyone having to wait for the Internal Revenue Service to take action against Greenblatt’s tax shenanigans. The IRS did receive a copy of the plan and didn’t object to it, but may have thought that since it could always disallow the deductions later if the plan got confirmed and since it isn’t in the business of preventing abuse of bankruptcy per se, there was no need for it to intervene in the bankruptcy. And even if the U.S. Trustee was not a party in interest, the bankruptcy or district court, since it can hardly be thought required to approve an unlawful plan of reorganization, need not turn a deaf ear when the U.S. Trustee, or anyone else for that matter, argues the plan’s unlawfulness. Id.
As for the tax tale here, ultimately it involves Greenblatt, who owned or controlled all the entities involved and caused a loan to be made from one of those entities to South Beach and caused South Beach to proclaim bankruptcy. (Posner says that South Beach once was a broker dealer but really had nothing going at the time of this transaction.) South Beach’s disclosure statement says that the purpose of the bankruptcy is to monetize South Beach’s net operating losses. South Beach had no use for the losses, having no income. The idea was to permit Scattered to benefit from them–South Beach would be transferred to Scattered in the bankruptcy, and Scattered could then provide a capital infusion to South Beach so that South Beach could earn income (instead of Scattered) and use the losses. The limitations in the Code under section 382 might not apply or the special rules in 382(l)(5) might save the losses, Posner says (though he notes that the record in the case is too scattered to be sure). So Posner assumes that section 382 was not an insuperable hurdle. Posner concludes that Section 269,however, does pose a challenge: a change from a beneficial to an actual owner doesn’t trigger the provision, but Scattered does not appear to be the beneficial owner of South Beach prior to the transaction (even though Greenblatt probably is). Anyway, Posner concludes, the fact that the tax scheme probably wouldn’t have been successful doesn’t matter as far as the decision to disallow bankruptcy when there is nothing but a tax avoidance purpose. “The object of bankruptcy is to adjust the rights of the creditors of a bankrupt company; it is not to allow a solvent company to try to lighten its tax burden.” Id.
Posner also concludes that the plan had to be rejected since it wasn’t made in good faith. South Beach started out solvent when Greenblatt caused the series of transactions to take place that would put South Beach in bankruptcy and Greenblatt (he hoped) benefitting from tax attributes that otherwise would have been lost. There was no real debt or real creditors, and the sole creditor is an “insider” so the case simply doesn’t belong in bankruptcy court. The court suggests that the misuse of the bankruptcy court for a tax evasion scheme raises “serious ethical and perhaps legal concerns” –for Greenblat and the parties in the bankruptcy proceeding, and for their legal advisers as well. The Court invites the US Trustee to seek sanctions against the parties and their law firms for abuse of the bankruptcy proceedings and frivolous law suits, and orders the attorneys to show cause why they should not be sanctioned!!!