Arrowsmith v. United States (In re Health Diagnostic Lab., Inc.)

• Decision Date: 06 December 2017
• Docket Number: Case No. 15–32919 (Jointly Administered),AP No. 17–04300
• Citation: 578 B.R. 552
• Court: U.S. Bankruptcy Court — Eastern District of Virginia
• Parties: IN RE: HEALTH DIAGNOSTIC LABORATORY, INC., et al., Debtors. Richard Arrowsmith, as Liquidating Trustee of the HDL Liquidating Trust, Plaintiff, v. United States of America, et al., Defendants.

578 B.R. 552

IN RE: HEALTH DIAGNOSTIC LABORATORY, INC., et al., Debtors.

Richard Arrowsmith, as Liquidating Trustee of the HDL Liquidating Trust, Plaintiff,

v.United States of America, et al., Defendants.

Case No. 15–32919 (Jointly Administered)

AP No. 17–04300

United States Bankruptcy Court, E.D. Virginia, Richmond Division.

Signed December 6, 2017

Cullen Drescher Speckhart, Wolcott Rivers Gates, Richmond, VA, for Plaintiff.

Kieran O. Carter, Ari David Kunofsky, Department of Justice, Tax Division, Karen Ruth Cordry, Nat'l Ass'n of Attorneys General, Washington, DC, Jill Bowers, Office of the Attorney General, Sacramento, CA, Ross A. Hoogerhyde, State of Colorado Department of Law, Denver, CO, Brittany Bolton Wilson, Georgia Department of Law, Atlanta, GA, James D. Newbold, Office of the Illinois Attorney General, Chicago, IL, Kimberly Bowden Stephens, Compliance Division, Baltimore, MD, Katherine A. Kakish, Michigan Department of Attorney General, Detroit, MI, Christos A. Katsaounis, PA Department of Revenue, Harrisburg, PA, Mark K. Ames, Taxing Authority Consulting Services PC, Midlothian, VA, Charles M. Allen, Goodman Allen Donnelly PLLC, Glen Allen, VA, Kevin J. Funk, DurretteCrump PLC, Richmond, VA 23219, Robert S. Hertzberg, Deborah Kovsky–Apap, Pepper Hamilton LLP, Southfield, MI, Jesse N. Silverman, Dilworth Paxson LLP, Philadelphia, PA, Theresa M Anzivino, Wisconsin Department of Justice, Madison, WI, for Defendants.

MEMORANDUM OPINION

Kevin R. Huennekens, UNITED STATES BANKRUPTCY JUDGE

The Court must decide in this adversary proceeding whether subchapter S corporation status ("S corporation status") under Title 26 of the United States Code (the "Tax Code")¹ is considered "property" for the purposes of 11 U.S.C. §§ 544(b), 548. A hearing on that issue was held on November 30, 2017 (the "Hearing"), at which time the Court took the matter under advisement. For the reasons set forth below, the Court holds that S corporation status is not "property" for the purposes of 11 U.S.C. §§ 544(b), 548.

Jurisdiction and Venue

The Court has subject matter jurisdiction over this adversary proceeding pursuant to 28 U.S.C. §§ 157 and 1334, and the general order of reference from the United States District Court for the Eastern District of Virginia dated August 15, 1984. This is a core proceeding under 28 U.S.C. § 157(b). Venue is appropriate in this Court pursuant to 28 U.S.C. §§ 1408 and 1409.

Background and Procedural History

Health Diagnostic Laboratory, Inc. ("HDL") was a privately held company based in Richmond, Virginia, that offered clinical laboratory services to physicians around the country. Under HDL's business model, HDL processed blood tests it received from physicians and tested biomarkers for the indication of risk for cardiovascular disease, diabetes, and other illnesses. Afterwards, HDL would reimburse the referring physicians for the costs associated with collecting, processing, and handling the blood samples that they had sent to HDL for testing. In January of 2013, the United States Department of Justice ("DOJ") and United States Department of Health and Human Services' Office of Inspector General ("HHS OIG") commenced an investigation into HDL in connection with HDL's business practices including its payment of process and handling fees to the referring physicians as potential violations of the federal anti-kickback statute. HHS OIG issued a special fraud alert on June 25, 2014, advising that the payment of processing and handling fees to referring physicians could violate certain federal anti-kickback laws.

After the special fraud alert, negative publicity and lawsuits ensued. In April 2015, HDL agreed to a multi-million dollar settlement for alleged violations of the federal False Claims Act along with a corresponding corporate integrity agreement with HHS OIG. By that time, HDL's relationship with its prepetition secured lender, Branch Banking and Trust Company ("BB & T"), had become severely strained. HDL eventually defaulted under its BB & T loan facilities. In response, BB & T discontinued HDL's borrowing ability and cut off HDL's access to its existing accounts. With no ability to access its cash and with no alternative sources of financing immediately available, HDL was forced to file for protection under chapter 11 of Title 11 of the United States Code (the "Bankruptcy Code").²

On June 7, 2015 (the "Petition Date"), HDL, Central Medical Laboratory, LLC, and Integrated Health Leaders, LLC (the "Debtors") commenced bankruptcy cases (the "Bankruptcy Cases") by each filing a separate voluntary petition for relief under chapter 11 of the Bankruptcy Code in the United States Bankruptcy Court for the Eastern District of Virginia (the "Court").³ On June 16, 2015, the United States Trustee for the Eastern District of Virginia appointed a statutory committee of unsecured creditors in accordance with section 1102 of the Bankruptcy Code (the "Committee").

HDL's Corporate and Tax Structure

As of the Petition Date, HDL had a four-member Board of Directors (the "Board"), which included Noel L. Bartlett, Robert S. Galen, Joseph P. McConnell, and George Russell Warnick. HDL had 19 shareholders who each owned various percentages of stock.⁴ Due to its corporate and shareholder attributes, HDL had the capacity to qualify as a "small business corporation" as defined by 26 U.S.C. § 1361(b).

On or about February 16, 2009, HDL filed an election to be classified as an S corporation under 26 U.S.C. § 1362, pursuant to unanimous shareholder consent as required by 26 U.S.C. § 1362(a)(2). Correspondingly, HDL filed S corporation elections with the State of New York Department of Taxation and Finance, the State of Arkansas Department of Finance and Administration, and the State of Mississippi Department of Revenue. Every other state where HDL did business either accepted the federal S corporation status election or did not recognize S corporation status.⁵

In accordance with Section 12(b) of the HDL Shareholders' Agreement, HDL made distributions to its shareholders as means to reimburse them for HDL's pass-through tax liability.⁶ HDL also made direct payments to the Internal Revenue Service (the "IRS") and the State Taxing Authorities on behalf of the shareholders. Every year, HDL filed IRS form 1120S, which included a schedule K–1 for each shareholder ("Schedule K–1") as it was required to do by section 6037(c)(1) of the Tax Code. HDL submitted corresponding forms to the State Taxing Authorities. Personally, the shareholders included on their individual tax returns the income, deductions, credits and other items displayed on the Schedules K–1.⁷

On January 1, 2015, HDL filed a Notice of Termination of HDL's S corporation status with the IRS and the State Taxing Authorities. As required by federal law, a majority of HDL's shareholders had voted in favor of revoking HDL's S corporation status. Consequently, as of the Petition Date, HDL was subject to C corporation tax.

Bankruptcy Proceedings

On September 17, 2015, the Court entered an order (the "Sale Order"), which authorized the sale of substantially all of the Debtors' assets to True Health Diagnostics, LLC ("True Health") under the terms of an Asset Purchase Agreement ("APA").⁸ On September 29, 2015, True Health acquired substantially all of the Debtors' operating assets. On May 12, 2016, the Court entered an order (the "Confirmation Order"),⁹ which confirmed the Debtors' Modified Second Amended Plan of Liquidation (the "Plan").¹⁰ The HDL Liquidating Trust was formed pursuant the terms of the Plan on the Effective Date.¹¹ Through the Plan, 11 U.S.C. § 1123, and the trust agreement executed to implement the Plan, the HDL Liquidating Trust is the successor of the Debtors and the Committee.¹²

On June 7, 2017, the Liquidating Trustee commenced this adversary proceeding (the "Adversary Proceeding") by filing a complaint (the "Tax Complaint") against the United States Internal Revenue Service, State Taxing Authorities, and the Shareholder Defendants (the "Defendants"). See Complaint, Arrowsmith v. United States , No. 15–32919, APN 17–04300 (Bankr. E.D. Va. June 7, 2017), ECF No. 1. Counts 1 through 4 of the Tax Complaint seek to avoid the revocation of the Debtors' S corporation status as a fraudulent transfer under sections 544(b) or 548 of the Bankruptcy Code. See id. at 20–24. The United States filed a motion to dismiss (the "Motion to Dismiss") the Tax Complaint under Rule 7012(b)(6) of the Federal Rules of Bankruptcy Procedure (the "Bankruptcy Rules") on July 12, 2017. See United States' Motion to Dismiss and Brief in Support, Arrowsmith v. United States , No. 15–32919, APN 17–04300 (Bankr. E.D. Va. July 12, 2017), ECF No. 4. The United States argued in Section IV(B) of its Motion to Dismiss that the claims asserted against it in "[c]ounts 1 through 4 regarding the ‘un-revocation’ of S corporation status" should be dismissed "because a debtor's tax status is not ‘property.’ " Id. at 4, 29–31.

The Court scheduled the Hearing to determine the sole issue raised in Section IV(B) of the Motion to Dismiss of whether S Corporation status was considered "property" for the purposes of the fraudulent transfer provisions of 11 U.S.C. §§ 544(b), 548 (the "Hearing Issue"). See id. at 29–31 § IV(B). The Court ordered the other Defendants named in the Tax Complaint to "(a) file a motion, brief, or joinder regarding the Hearing Issue or (b) confirm in writing to counsel for the Plaintiff that such defendant waives the right to file any pleading regarding the Hearing Issue and agrees to be bound by the Court's disposition of the Hearing Issue" on or before September 25, 2017. See Order, Arrowsmith v. United States , No. 15–32919, APN 17–04300 (Bankr. E.D. Va. Sept. 1, 2017), ECF No. 23. All but two of the Defendants named in the Tax Complaint chose to join the United States' Motion to Dismiss.¹³

Federal Tax Law Framework

Under the Tax Code, the "default" tax status for corporate entities in the...