A recent U.S. Supreme Court decision that addressed so-called federal common law will generate plenty of discussion among legal scholars, but for tax accountants the outcome is clear and straightforward: Affiliated companies filing a joint tax return should have a tax allocation agreement.
At issue in Simon Rodriguez, as Chapter 7 Trustee for the Bankruptcy Estate of United Western Bancorp v. Federal Deposit Insurance Corp., as Receiver for United Western Bank, decided Feb. 25, 2020, was the Bob Richards rule, a nearly half-century old precedent that caused a split in the federal circuit courts of appeal about how courts should view disputes over tax refunds paid to an affiliated group of corporations. Under Bob Richards, a subsidiary whose losses prompted a refund presumably receives the refund unless the parties have agreed otherwise. The U.S. Court of Appeals for the Ninth Circuit crafted the rule, relying on a disputed authority to create a common law rule to govern such controversies. Over the years, other circuits have expanded on the rule, while some circuits rejected it.
The Internal Revenue Service allows affiliated companies to file consolidated returns and if there is a refund, it issues a check to the group’s parent company. It does not get involved in how those funds are allocated within the group. Trouble most often comes when a bankrupt entity is issued a refund, since the refund is considered property of the bankruptcy estate, subject to distribution to pay creditor claims.
That is what happened in Rodriguez. United Western Bank in Denver fell into receivership, coming under control of the Federal Deposit Insurance Corp. (FDIC). The bank’s parent, United Western Bancorp Inc., also faced problems and filed for bankruptcy protection. The IRS issued a $4 million refund to Rodriguez, as bankruptcy trustee for United Western Bancorp, the holding company, on behalf of the consolidated group that included the FDIC. The FDIC, however, claimed that the refund belonged to it as receiver for the subsidiary bank.
Rodriguez won a summary judgment in U.S. Bankruptcy Court only to have the U.S. District Court reverse the decision. Unlike the bankruptcy court, the district court relied on the Bob Richards rule, awarding the refund to the affiliate that generated the loss and making it subject to recovery by the FDIC. On appeal, the U.S. Court of Appeals for the Tenth Circuit affirmed the district court’s ruling, again citing the 1973 Ninth Circuit case involving the Bob Richards automobile dealership.
Federal law offers no guidance for tax refund allocation
Federal law does not offer much guidance on distribution of refunds in such cases. In response, corporate groups may use tax allocation agreements to specify each member’s tax liability along with its share of any refunds. But if there is no tax allocation agreement, or if the agreement is not clear in its intent, courts can either turn to state law or rely on the Bob Richards rule, which says that the refund belongs to the member of the corporate group that generated the loss.
Some federal courts have ruled that the Bob Richards rule should always be followed unless a tax allocation agreement unambiguously outlines other terms. In the Tenth Circuit’s ruling in Rodriguez, the court awarded the refund to the FDIC, even though the corporate group had a tax allocation agreement. The Tenth Circuit said the tax allocation agreement did not reject the Bob Richards rule in a sufficiently unambiguous way, a decision that many believe embodied the frustrating lack of certainty in the Bob Richards rule.
With its February decision, the Supreme Court tossed the Bob Richards rule into the graveyard of case law. The high court’s unanimous decision, written by Justice Neal Gorsuch, struck down the Bob Richards rule and left it to the lower courts on remand to decide the dispute. But the court firmly rebuked the Bob Richards rule as not being a legitimate exercise of federal common lawmaking, which it said is necessary only in very limited circumstances. The Court made clear that tax allocation agreements are to be construed in accordance with the law of the state governing the agreement, such as the state’s law of agency, trusts, and contracts. “State law is well-equipped to handle disputes involving corporate property rights,” Justice Gorsuch wrote.
Ruling brings certainty
The court’s skeptical view of federal common law may affect other areas of the law, but the overriding effect of the court’s decision for tax and bankruptcy practitioners is to bring certainty to who owns tax refunds in consolidated corporate groups. If there is no agreement or it is disputed, state laws will apply.
Still, state laws will not always provide sufficient guidance in these situations. Case law in the states will continue to evolve in this area as disputes emerge not only in bankruptcy but in other instances where the parent and an affiliate company disagree on the allocation of tax liabilities and assets. The IRS continues to offer little guidance, perhaps because it is more concerned with collection of taxes than it is the distribution of refunds among affiliated companies. While tax allocation agreements are not new, this is a reminder that they should be written to cover every contingency, removing all doubt about the intentions of each of the corporate entities. Every corporate group that files taxes under the parent should have a tax allocation agreement in place to reduce the possibility of litigation and ensure that the parties’ intent is carried out.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Mark E. Haynes is a commercial litigation attorney at Ireland Stapleton in Denver. He represents businesses and individuals in commercial litigation, including bankruptcy litigation. He can be contacted at firstname.lastname@example.org or 303.628.3609.