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Failed Banks and The Controversy Over Tax Refunds

Benedict Kwon

uring the current economic downturn, a significant number of banks have failed in the United States. In 2010, 157 banks were shuttered by the Federal Deposit Insurance Corporation (FDIC).1 Most

banking organizations are structured so that a parent holding company (Parent) owns all of the stock of an operating bank (Bank). When the FDIC assumes control over a Bank, it gathers the Banks assets in an attempt to satisfy the Banks liabilities. These assets include claims the Bank may have against third parties. As is often the case, the assets of the Bank are insufficient to satisfy the Banks liabilities. The FDIC will pursue aggressively any claims previously held by the Bank. Against this background is a common issue that arises between the Parent and the FDIC, namely federal and state income tax refunds (Refunds) of the group. The Parent, as owner of the stock of the Bank, will assert that the Refunds belong to the Parent. The FDIC, however, will assert that the Banks losses generated the Refunds and therefore belong to the Bank. There are currently a number of United States bankruptcy and district court cases addressing this issue. Yet there is no clear authority resolving this issue, and at times, courts have taken inconsistent positions. In light of the lack of clear authority, a Parent may be advised to discuss settlement with the FDIC. Unfortunately the FDIC often takes an aggressive negotiating position and unless a strong tax position is asserted, the success of the settlement negotiations from the Parents perspective can be limited. The purpose of this article is to examine the analysis applied by bankruptcy and district courts regarding the sharing of Refunds between the Parent and the Bank. This article will also discuss the potential strategies that may be employed by a Parent to maximize its recovery of Refunds. Introduction Before a bank is seized by the FDIC, it may have a number of successful operating years, generating significant profits and significant tax liabilities. During the recent economic downturn, however, many banks suffered severe losses that more than wiped out prior profits. The Internal Revenue Code allows for a leveling of tax liability over several tax years by carrying back net operating losses (NOL) to prior years in which taxes were paid. When the NOLs are applied to reduce the taxable income of prior years, a tax refund may result.2 The general rule is that the parent of a consolidated group controls the tax filings for the consolidated group, including any claims
Benedict Kwon
Benedict Kwon is a shareholder in the firm of Stradling Yocca Carlson & Rauth in Newport Beach, California. This article does not constitute tax, legal, or other advice from Stradling Yocca Carlson & Rauth, which assumes no responsibility for advising the reader with respect to tax, legal, or other consequences arising from the readers particular circumstances.

for tax refunds.3 If this general rule were controlled, the FDIC would have a significant barrier to overcome in seizing its share of the Refunds since the Parent would control the filing and collection of Refunds. Fortunately for the FDIC, there is a specific Treasury Regulation that gives it an arrow for its quiver. Treasury Regulation section 301.6402-7 authorizes the FDIC to file a tax return on behalf of the consolidated group and claim a Refund for the loss generated by the Bank. In effect, the regulation authorizes the filing of competing tax returns, thereby encouraging disputes between the FDIC and the Parent. The original purpose of the regulation was to deal with defunct Parent companies that failed to file tax returns, including refund claims, on behalf of the consolidated group. Under the general rule, the FDIC could not file a tax return on behalf of the consolidated group. The regulation was meant to alleviate this situation by allowing some member, namely the FDIC, to file on behalf of the consolidated group. It should be noted that Treasury Regulation section 301.6402-7 specifically provides that the regulation is only determinative of who is to be paid the refund and is not determinative of the ownership of the refund among the members of the consolidated group. This was obviously an attempt by the Internal Revenue Service (IRS) to avoid being placed in the awkward position of determining the owner of the Refund. If the FDIC avails itself of the above procedure, the Parent (assuming that it has filed for bankruptcy protection) can prevent the FDIC from receiving the refund by filing a temporary restraining order against the FDIC on the grounds that the FDIC is violating the automatic stay provided to a debtor under the U.S. Bankruptcy Code and attempting to take for its own benefit an asset of the Parent. The bankruptcy court will usually order that any Refunds paid by the IRS be placed in escrow pending determination by a court of the true owner of the Refund. As stated above, the law is not clear as to the identity of the true owner of the Refund.
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Failed Banks and The Controversy Over Tax Refunds

Determining Ownership of the Tax Refund The leading case on the issue of ownership of the Refund is In re Bob Richards Chrysler-Plymouth Corp., Inc.,4 in which the Ninth Circuit held that nothing in the Internal Revenue Code compelled a finding that a tax saving must or should inure to the benefit of the parent company or to the benefit of the company that sustained the loss. The court found that if there was a tax allocation agreement, or if one could be implied, the parties could adjust the liability between themselves. Absent such an agreement, allowing the parent to keep the refund that was based on the subsidiarys loss unjustly enriched the parent. A tax allocation agreement is a contractual agreement between the members of a consolidated group, specifying the sharing of tax liabilities and tax refunds among the members of the group. There are several examples of cases where courts were presented with tax allocation agreements. Generally speaking, ownership of the Refund depends on the terms of the agreement. If the terms of the agreement establish a debtor-credit relationship, then the FDIC is treated as merely a creditor of the Parents estate, and the Refund belongs to the Parent. If the tax allocation agreement creates a trustee-beneficiary relationship between the Parent and Bank, the Refund is shared between the Parent and Bank based on their respective shares of NOLs that generated the Refund. In re First Central Financial Corp.,5 the Parent and Bank were parties to a tax allocation agreement. The court determined that the agreement controlled in the absence of overreaching or a breach of fiduciary duty by the Parent. Based on the terms of the tax allocation agreement, the court concluded that a debtorcreditor relationship was established. The court noted that there was no requirement in the tax allocation agreement for the tax refunds to be segregated from the general assets of the Parent, and the tax allocation agreement provided no terms as to how the refunds should be handled during the 30 day period that the Parent could hold the refunds. Accordingly, the court concluded that the refunds were part of the Parents bankruptcy estate. In Franklin Savings Corp. v. Franklin Savings Assn,6 the Parent and the Bank were parties to a tax allocation agreement. The court noted that the agreement between the parties referred to reimbursement to the Bank, which was inconsistent with the notion that the Bank owned the refunds. The court concluded that the Bank had an unsecured claim for its portion of the refund. Under Kansas law, the court stated that there were no grounds to justify the imposition of a constructive trust. It is interesting to note that in the Franklin Savings Corp. case, the Parent did not fund any of the estimated tax payments that generated the refund, nor did the

Parent generate the losses that gave rise to the tax refund. In Team Financial Inc. v. FDIC,7, the Chief Bankruptcy Judge for the U.S. Bankruptcy Court for the District of Kansas found that the tax allocation agreement under review created a debtor-credit relationship and the tax refunds were property of the Parents estate. The court noted language in the tax allocation agreement regarding the obligation of the Parent to pay members of the consolidated group. Further, there was nothing in the tax allocation agreement that required the tax refund to be segregated, that required the refund to be held in trust, or that prohibited the Parent from using the tax refund. There are a number of other decisions where courts have concluded that a debtor-creditor relationship was created based on the terms of the tax allocation agreement.8 From the Parents perspective, a conclusion by the bankruptcy courts that a debtorcreditor relationship exists between the Parent and the Bank is a total victory. The court would be required to award the full amount of the Refund to the Parents estate. There are, however, cases where the court concluded that the relationship between the Parent and Bank was a trust relationship. Under this characterization, the Parent would be treated as filing for Refunds on behalf of the Bank. In BSD Bancorp, Inc. v. FDIC,9 the court examined the economic reality of the situation, rather than simply examining the words of the tax allocation agreement. The court stated that except in the unusual circumstance where the Parent could borrow the consolidated groups tax refund, the tax allocation agreement required the Parent to give the Bank its share of the refund in cash immediately. The court stated that this suggested a principal-agent relationship with the Parent holding the refunds in trust for the Bank. Under a trust relationship analysis, the courts will look at the equities of the situation and allocate the tax refund based on the members of the group whose losses generated the Refund. In general, the Parent of the group will not have incurred significant losses. Thus, the application of a trust relationship type analysis to the Refunds could result in substantially all of the Refunds being awarded to the Bank. The above case law demonstrates that courts apply varying rules in deciding ownership of Refunds. Often, a highly factual inquiry will be made into the provisions of the tax allocation agreement in reaching a decision. Uncertainty in the law and the highly factual nature of the legal inquiry will often drive both the Parent and the FDIC to seek a settlement with respect to the Refunds. As mentioned above, the FDIC is often aggressive in its negotiations. The Parent will be well advised to use various tax strategies to improve its negotiating leverage.
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Failed Banks and The Controversy Over Tax Refunds

Settlement Negotiations with the FDIC As discussed above, if a court were to decide that the relationship between the Parent and Bank is a creditor-debtor relationship, then the Parent would achieve a total victory and the Refund would be treated as property of the Parents bankruptcy estate. The FDIC would merely possess an unsecured claim with respect to the assets of the Parent. Under a trust relationship analysis, the court would examine the proportion of losses generated between the Parent and the Bank. The strategy under this scenario would be to maximize the share of the consolidated net operating losses generated by the Parent. One possibility is for the Parent to claim a worthless stock deduction. Section 165 allows for a worthless stock deduction when a stock becomes worthless during the taxable year. In general, worthlessness is found to exist when an identifiable event has occurred to fix the date the stock becomes worthless. The statute has never defined when an identifiable event has occurred. Rather, case law has determined when a security becomes worthless. In United States v. S.S. White Dental Mfg. Co., 47 S. Ct. 598 (1927), the court concluded that the stock became worthless when the German government seized the assets of a subsidiary. In Richards v. Commissioner, T.C. Memo 1959-64, the court concluded that a stock became worthless when the assets of the company totaled $777,000 and the liabilities totaled $822,000. There is a complicating factor in claiming a worthless stock deduction in the consolidated return context. Treasury Regulation section 1.1502-80(c)(1) requires the timing of the worthless stock deduction to be delayed until a later date. This regulation provides that subsidiary stock is not treated as worthless under section 165 until immediately before the earlier of the time: a) The stock is worthless within the meaning of section 150219(c)(1)(iii); or b) The subsidiary for any reason ceases to be a member of the group. Treasury Regulation section 1502-19(c)(1)(iii) provides that worthlessness occurs at the time all the subsidiarys assets (other than its corporate charter and those assets, if any, necessary to satisfy state law minimum capital requirements to maintain corporate existence) are treated as disposed of, abandoned, or destroyed for federal income tax purposes. The particular facts of the situation may prevent qualification for a worthless stock deduction under the literal terms of the above regulation. However, even in cases where the Parent cannot comply with these requirements, plausible arguments can still be made that
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the security is worthless. However, these arguments are beyond the scope of this article. Such arguments would generally provide that the intent of the statute should allow for an earlier claim of the worthless stock deduction. If a worthless stock deduction can be successfully claimed by the Parent, the FDIC faces a particularly chilling proposition. Not only is the Parents share of overall consolidated net operating losses suddenly increased, but also the consolidated return regulations may in certain circumstances treat the FDICs share of consolidated net operating losses as having decreased. The ability to use a particular strategy will depend on the particular facts. Conclusion The prospect of contested Refunds will continue to be fraught with uncertainty until case law becomes more certain with respect to the determination of ownership of Refunds. Until then, Parents are well advised to engage in settlement negotiations with the FDIC. The FDIC will continue to be very aggressive in their posture. Thus, it will be necessary for the Parent to present forceful and cogent arguments in order to reach a successful settlement with the FDIC. n Endnotes 1 2 Section 172 of the Internal Revenue Code. Unless otherwise indicated, section references are to the Internal Revenue Code of 1986, as amended. 3 Treas. Reg. 1.1502-77(a)(1). 4 473 F.2d 262 (9th Cir. 1973). 5 269 B.R. 481 (Bankr. E.D. N.Y. 2001). 6 159 B.R. 9 (Bankr. D. Kan. 1993). 7 Adv. Proc. No. 09-5084 (April 27, 2010). 8 See RTC v. Franklin Savings Corp., 182 B.R. 859 (Bankr. D. Kan. 1995). As a general rule, Parent holds refunds in trust for the subsidiary, but it can be varied by agreement. Here, the agreement showed the intent was to create a receivable. According to the agreement, which had been submitted to the regulators for approval, amounts were to be reimbursed under certain circumstances. See also U.S. v. MCorp Financial, Inc., 170 B.R. 899 (S.D. Tex. 1994) (finding language in agreement created a debtor-creditor relationship). 9 No. 93-12207 (S.D. Cal. 1995).