Spring 2006 • Issue 21, page 14

Does Constructive Trust Raise Harmed Parties' Claims Above Pre Receivership Tax Debts?

By Rosen, Charles*

Suppose you are the receiver for a defendant business, an investment scam or similar venture where claimants were harmed by the fraudulent acts (civil or criminal) of the receivership entity or its principals. Your appointing order directs you to take control of the entity’s assets, recover misappropriated assets and/or funds, and reduce the assets to cash for distribution to valid claimants. As additional duties you are directed to reconcile financial records, incur and pay appropriate administrative expenses, file appropriate reports with the court and regulatory agencies, and file and pay tax returns of the receivership estate.

Your sleuthing determines that the defendant(s) is/are indebted up to their collective eyeballs to taxing authorities — either pre-receivership tax debts or tax debt incurred as the result of the receiver’s sales. Can you as receiver legally avoid paying these taxes and preserve the estate’s assets for the harmed parties?

First (and most important!) — Federal statutory law and reported cases make it clear that you as receiver may pay your reasonable costs of administration (including any taxes on receivership administrative operations) before pre-receivership tax liens attach. Thus be sure to first make a detailed application to the court for allowance of your fees and expenses and distribute what the court allows.

Second, in cases where it can be established that creditors / investors of /in the receivership entity were indeed defrauded, the receiver may ask the Court to determine (by motion or otherwise) that the funds held by the receiver are held in ‘constructive trust’ by her/him for the benefit of the defrauded parties.

State or federal law will determine whether and to what extent a constructive trust will be imposed over assets ostensibly belonging to the defendant receivership entity. Successful imposition of a constructive trust will endow the trust beneficiaries – the defrauded creditors — with a non-statutory priority over other creditors (including tax creditors) of the receivership estate.

Speaking generally, a constructive trust may be imposed to exclude property from a defendant’s estate as a remedy where the debtor wrongfully deprived another party of some right, title, benefit, or interest in the indicated property. Proof that the debtor acquired the property in issue by wrongful or fraudulent conduct may not be required to establish a constructive trust, however. Instead, the remedy may be imposed by the court when it appears the debtor entity would be unjustly enriched if permitted to retain interest in the property. A motion seeking the imposition of a constructive trust should include substantial evidentiary support for the allegation of fraud, however. The court should include its findings of fact validating the fraud theory and constructive trust determination in its order.

But the best case in the world for imposition of a constructive trust will be for naught if notice of your motion – including a copy of the pleading and supporting documents, etc. – is not properly served on all appropriate taxing authorities and government attorneys.

Giving notice serves two purposes. First, it puts the government on notice of your action and allows the government to respond accordingly. Second, and even more important, it gives you as receiver a far better chance of prevailing against a later government attempt to set aside the court’s constructive trust order.

It is not uncommon for the Federal government to come into court months (or years) after a state court has granted a constructive trust motion, arguing that the court’s decision was in error because of a lack of jurisdiction or because it misunderstood applicable substantive law. If you, as a careful receiver, properly served the government with full notice of the intended action and the government failed to take part in the proceedings, the government will likely not appeal the court or bring a new action to overturn the constructive trust. Affording the government an adequate opportunity to timely object to jurisdiction will weaken any jurisdictional argument the government may wish to make after entry of the order.

What must a receiver do to ensure full notice (and complete disclosure) of the intended action to all interested agencies? I shall limit my suggestions to cases filed in either California Superior Court or in U.S. District Courts located in California. With respect to state agencies, be sure to give notice of the hearing and a copy of the motion by certified mail to each state taxing agency that might have a claim to the funds. All three California taxing authorities — the Franchise Tax Board, the State Board of Equalization and the Employment Development Department — maintain special procedures branches in Sacramento that are designed, in part, to serve as the conduit to the agency for service of process. Also be sure to serve the California Attorney General, also by certified mail, since that office is the state’s lawyer.

With respect to the Federal government, in most instances the taxing authority involved will be the Internal Revenue Service, but other taxing agencies or regulatory authorities like Customs (now a part of I.C.E.), the main U.S. Treasury, and the Securities and Exchange Commission (among many others) may be involved.

To provide notice to the IRS both notice and the pleading should be sent by certified mail to the Civil Suit Advisor in the Advisory Unit serving your geographic area of the court. This used to be part of the old IRS Special Procedures Branch and the old SPB mailing address may still be used.

Service of the notice and pleading should also be made by certified mail to the local U.S. Attorney’s office (in the Central and Northern Districts of California: address it to the Tax Division of the U.S. Attorney’s office). Finally, service by certified mail should be made on the United States Attorney General. This is best done by mailing the notice and moving papers to Chief, Tax Division – Civil Trial West, U.S. Department of Justice, P.O. Box 683, Ben Franklin Station, Washington, D.C. 20044 or to main Justice, at simply Washington, D.C. 20530.

Of course, by giving notice you are inviting government opposition to your motion. Even so it is wise to face this issue if it is going to be raised before you have disbursed all funds to other claimants.

*CHARLES F. ROSEN, ESQ. of the Law Offices of A. Lavar Taylor has substantial tax expertise involving receiverships and bankruptcy. Mr. Rosen served as a bankruptcy advisor for the Special Procedures Branch of the Internal Revenue Service for more than twenty years.