Corporate tax allocation agreements: No longer subject to federal common law

The U.S. Supreme Court in Rodriguez v. FDIC, 140 S. Ct. 713 (2020),unanimously struck down a federal common law interpretation of tax allocation agreements and further cautioned federal courts about federal common lawmaking.

Prior to the financial crisis of the late 2000s, United Western Bancorp, Inc. and its subsidiaries filed consolidated income tax returns with the Internal Revenue Service. One of the subsidiaries was United Western Bank. For the 2008 tax year, the parent company filed a consolidated tax return and reported taxable income for United Western Bank of $34.4 million. However, the financial crisis hit the bank hard and it suffered a $35.3 million loss for the 2010 tax year.

The Office of Thrift Supervision closed United Western Bank in January 2011 and appointed the Federal Deposit Insurance Company as receiver for the bank. As a result of the bank's receivership the parent company, United Western Bancorp, became insolvent and filed for bankruptcy under Chapter 11 in March 2012.

United Western Bancorp, on behalf of the consolidated group, carried back the losses generated in the 2010 tax year to 2008 and claimed a refund of $4.8 million. The FDIC, as receiver for the bank, filed a claim in the bankruptcy proceeding claiming that it was entitled to the tax refund. United Western Bancorp disagreed.

In April 2013, the bankruptcy proceeding was converted to Chapter 7 and a bankruptcy trustee was appointed.

After conducting an examination of the refund claim, the IRS issued a refund of $4.08 million. The FDIC, on behalf of the bank, and the trustee, on behalf of the parent company, battled as to who is entitled to that tax refund.

Procedural History

The Bankruptcy Court found that United Western Bank merely held a position as creditor compared to United Wester Bancorp and therefore found that the trustee was entitled to receive the refund. In re United Western Bancorp, Inc., 558 B.R. 409, 427-28 (Bankr. D. Colo. 2016). The district court reversed, holding that the tax allocation agreement of the consolidated group was ambiguous and that according to the agreement any ambiguities should be construed in favor of the bank.

The 10th U.S. Circuit Court of Appeals affirmed the district court's holding that the agreement created an agency relationship, as opposed to a debtor/creditor relationship, between United Western Bank and United Western Bancorp, which was consistent with federal common law. Thus, the bank was entitled to the tax refund. In re United Western Bancorp, Inc., 914 F.3d 1262, 1274 (10th Cir.).

Supreme Court Decision

For those of you who skip to the end of a decision to determine who won and who lost, the Supreme Court does not provide that sort of closure: "Who is [entitled to the tax refund] we do not decide." Instead, the court's focus was on the use of federal common law.

The Supreme Court noted that many consolidated tax groups have developed tax allocation agreements for the purpose of determining the group's tax liability, along with the share of any tax refund each member will receive. State law is replete with rules readymade for such tasks --rules for interpreting contracts, creating equitable trusts, avoiding unjust enrichment, and much more. However, some federal courts have taken a different path. For example, the 9th U.S. Circuit Court of Appeals in In re Bob Richards Chrysler-Plymouth Corp., 473 F.2d 262 (1973), held that in the absence of a tax allocation agreement, a refund belongs to the group member responsible for the losses that led to it. (In this case, United Western Bank generated the income, paid the tax and suffered the loss that created the net operating loss carryback to generate the tax refund.) This became the Bob Richards rule and has expanded over time to become "a general rule always to be followed unless the parties' tax allocation agreement unambiguously specifies a different result."

The Supreme Court was troubled by this expansive rule under federal common law: "As this Court has put it, there is 'no federal general common law.' Instead, only limited areas exist in which federal judges may appropriately craft the rule of decision. These areas have included admiralty disputes and certain controversies between States. In contexts like these, federal common law often plays an important role. But before federal judges may claim a new area for common lawmaking, strict conditions must be satisfied. The Sixth Circuit correctly identified one of the most basic: In the absence of congressional authorization, common lawmaking must be necessary to protect uniquely federal interests."

Here, there was no federal interest in deciding how a consolidated group should allocate a federal tax refund. The Supreme Court did find that there would be a federal interest in regulating how the IRS receives tax payments and how the IRS delivers tax refunds, but not in how the refund is distributed among the group. (This is even though the refund at issue was a federal tax refund whose ownership was being litigated in a federal bankruptcy proceeding.)

Having found no federal interest in deciding the ownership of tax refunds in federal consolidated groups, the Supreme Court struck down the Bob Richards rule and cautioned the federal judiciary about common law making: "We took this case only to underscore the care federal courts should exercise before taking up an invitation to try their hand at common lawmaking. Bob Richards made the mistake of moving too quickly past important threshold questions at the heart of our separation of powers. It supplies no rule of decision, only a cautionary tale."

Next Steps

The FDIC, on behalf of United Western Bank, and the trustee, on behalf of United Western Bancorp, head back to the 10th Circuit to have the case decided without the Bob Richards case law. This may be a temporary victory for the trustee as the 10th Circuit previously found an agency relationship between United Western Bancorp and United Western Bank and that the tax refund at issue belonged to the latter.

Observations

Practitioners and the federal judiciary should not be relying upon federal common law.

In the Tax Cuts and Jobs Act, Congress has generally removed the ability for taxpayers to carry back net operating losses to claim refunds from prior years which means, absent a law change, consolidated groups will not have as many fights over consolidated losses.

In 2014, the FDIC began requiring insured depository institutions, and their corporate affiliates, to have tax allocation agreements that provide that a parent company that receives a tax refund from a taxing authority obtains these funds solely as agent for the consolidated group on behalf of the group members. 