Darr v. United States (In re Telexfree, LLC)

• Citation: 615 B.R. 362
• Decision Date: 26 March 2020
• Docket Number: Adversary Proceeding No. 18-4091,Case No. 14-40987-MSH
• Parties: IN RE: TELEXFREE, LLC et al., Debtors Stephen Darr, as the Trustee of the Estates Of Telexfree, LLC, Telexfree, Inc. and Telexfree Financial, Inc., Plaintiff v. United States of America, Department of the Treasury, Internal Revenue Service, Defendant
• Court: United States Bankruptcy Courts. First Circuit. U.S. Bankruptcy Court — District of Massachusetts

615 B.R. 362

IN RE: TELEXFREE, LLC et al., Debtors Stephen Darr, as the Trustee of the Estates Of Telexfree, LLC, Telexfree, Inc. and Telexfree Financial, Inc., Plaintiff

v. United States of America, Department of the Treasury, Internal Revenue Service, Defendant

Case No. 14-40987-MSH

Adversary Proceeding No. 18-4091

United States Bankruptcy Court, D. Massachusetts.

March 26, 2020

Andrew G. Lizotte, Esq., Harold B. Murphy, Esq., Charles R. Bennett Jr., Esq., Murphy & King, Professional Corporation, Boston, MA, for the plaintiff, Stephen Darr, Trustee of the Estates of TelexFree, LLC, TelexFree, Inc., and TelexFree Financial, Inc.

Lauren Hume, Esq., U.S. Department of Justice, Tax Division Washington, DC, for the defendant, Internal Revenue Service

MEMORANDUM OF DECISION ON MOTIONS FOR SUMMARY JUDGMENT

Melvin S. Hoffman, U.S. Bankruptcy Judge Stephen Darr, the chapter 11 trustee of the estates of TelexFree, LLC, TelexFree, Inc., and TelexFree Financial, Inc.,¹ filed a five-count complaint against the Internal Revenue Service ("IRS") seeking declaratory judgments in connection with disputes pertaining to TelexFree's 2012, 2013, and 2014 federal income tax returns. The IRS's response to the complaint included a counterclaim seeking, in part, to recover more than $15 million that the IRS claims it disbursed to the trustee in error after the trustee filed TelexFree's 2013 tax return.

The parties initially filed cross-motions for summary judgment on counts 4 and 5 of the complaint. Pl.'s Mot. Summ. J., ECF No. 12; Def.'s Cross-mot. Partial Summ. J., ECF No. 21. These counts concern whether the IRS's claims against TelexFree's estate are entitled to administrative expense treatment. Subsequently, the IRS filed a separate motion for summary judgment on the remaining counts of the complaint (counts 1-3) and on its counterclaim. Def.'s Second Mot. Partial Summ. J., ECF No. 55. While the trustee did not cross-move for summary judgment on those claims, in his opposition to the IRS's motion he requested relief under Federal Rule of Civil Procedure 56(f) which gives the court discretion to grant summary judgment to a non-movant.

After considering the parties' briefs and statements of undisputed fact and the arguments of counsel at hearings on the motions, I now set forth my rulings and my reasoning.

UNDISPUTED FACTS

1. Background

Beginning in 2012, TelexFree purported to be in the business of selling voice over internet protocol ("VoIP") international telephone subscription packages for a monthly fee. Customers (the "Participants") who subscribed could download computer software and register their telephone numbers with TelexFree to make internet-based long-distance telephone calls. But TelexFree wasn't what it appeared to be. Sales of VoIP services generated only about 1% of TelexFree's revenue. The other 99% came from membership subscriptions paid by the Participants.

Upon signing up, each Participant would receive one or more TelexFree user accounts. Participants were promised financial incentives (referred to as "credits") which were deposited into their user accounts each time they recruited a new Participant, posted a daily internet advertisement or sold a new membership plan. Participants could access the TelexFree program in two ways. Via a lower-tier investment, a Participant could pay TelexFree $339 and agree to post one TelexFree-related internet advertisement per day for a year.² If she did so, then each week the Participant was entitled to a VoIP package from TelexFree. The Participant could redeem the package for $20 in credits. Thus, if a Participant posted an advertisement each day and redeemed the resulting credits for cash, she could earn $20 per week ($1,040 per year), a 207% return on her investment, plus additional amounts if she sold VoIP packages. Or, a Participant could make a higher-tier investment by paying TelexFree $1,425 and agreeing to post five internet advertisements each day for a year. If he did so, the Participant was entitled to five VoIP packages from TelexFree per week, which he could redeem for $100 in credits. So, if a high-tier Participant posted five advertisements each day and redeemed the resulting credits for cash, he could collect $100 per week, or $5,200 per year, a 265% return on his investment.

Participants also could earn credits by recruiting other Participants into the TelexFree scheme. For recruiting a new lower-tier Participant, one could earn $20 in credits. Recruiting a new higher-tier Participant would generate $100 in credits. At the same time, the Participant who had recruited the recruiter would receive additional money, hence the pyramid nature of the scheme.

Participants could exchange credits for cash, or they could use credits to purchase additional membership plans or VoIP packages. Membership plans or VoIP packages could be purchased in two ways: through a direct transaction when the Participant purchased the plan or package from TelexFree and paid TelexFree directly or through a so-called "triangular transaction" where a Participant purchased a plan or package through another Participant who in turn paid for the purchase by instructing TelexFree to redeem accumulated credits in his user account.

As 2012 progressed, TelexFree's business evolved away from the sale of VoIP plans for actual use into the recruiting of an ever-widening base of Participants on the promise of triple-digit investment returns. This was the pyramid scheme. The money to pay those returns was generated from the membership fees paid by lower level Participants. This was the Ponzi scheme.

TelexFree was a hybrid Ponzi and pyramid scheme that operated in the United States from 2012 until 2014, when its founders were criminally charged, its operations closed, and it declared bankruptcy. It is considered one of the largest such schemes in U.S. history, with approximately $1.7 billion lost and one million participants, many of them immigrants, defrauded.

Darr v. Dos Santos (In re TelexFree, LLC) , 941 F.3d 576, 579 (1st Cir. 2019).

On April 15, 2014, the Securities and Exchange Commission ("SEC") brought an action against TelexFree and others in the United States District Court for the District of Massachusetts asserting that TelexFree and its affiliates were engaged in an illegal Ponzi/pyramid scheme and in the fraudulent and unregistered offering of securities. At or around the same time, Homeland Security Investigations seized TelexFree's assets, books, and records.

2. Bankruptcy and the Trustee's Appointment

On April 13, 2014 (the "Petition Date"), two days before the SEC commenced its action, TelexFree and its affiliates filed voluntary chapter 11 petitions in the United States Bankruptcy Court for the District of Nevada. Shortly thereafter the cases were transferred to this Court. Mr. Darr was appointed chapter 11 trustee to administer all three bankruptcy estates on June 6, 2014. Since the Petition Date TelexFree has generated no revenue.

3. 2012 Tax Returns

In September 2013, prior to the Petition Date, TelexFree filed its 2012 federal income tax return (the "2012 Original Return"). It reported net income of over $2 million with a tax due of $686,121 plus an estimated tax penalty due of $6,733, for a total amount owed of $692,854. At the end of September 2013, the IRS issued an assessment for taxes and penalties against TelexFree totaling $885,105.24. TelexFree paid the assessment in full by mid-December.

In September 2016, the trustee filed an amended income tax return for TelexFree for the 2012 tax year (the "2012 Amended Return"). This return reported no tax due and requested a refund of the amount paid in 2013. In October 2017, the IRS disallowed the trustee's refund claim on the basis that, among other things, TelexFree's advertising expenses were either not deductible as ordinary and necessary business expenses, or, to the extent they were credits owed to Participants, were not deductible because the amounts were not actually paid or likely to be paid.

In March 2018, the trustee filed a second amended return for 2012 (the "2012 Second Amended Return") reporting that TelexFree had no taxable income, owed no tax and was entitled to a refund. Again, the deductions claimed included TelexFree's advertising expenses and credits owed to Participants.

4. 2013 Tax Returns

The due date for TelexFree to file its 2013 federal income tax return was March 17, 2014. On or about March 31, 2014, about two weeks before the Petition Date, without filing a return, TelexFree made a payment to the IRS in the amount of $15,792,982 to be applied to its anticipated 2013 federal income tax liability.

In September 2016, the trustee filed TelexFree's federal income tax return for 2013 (the "2013 Original Return"). It reported a taxable loss of $2,101,985,935 and sought a refund of $15,858,111. Included in the loss was a bad debt expense of $186,344,898 resulting from the write-off of a worthless debt owed to TelexFree by a related entity, Ympactus Comercial, Ltda. The trustee also claimed deductions based on amounts TelexFree owed to Participants as credits.

In December 2016, the IRS sent a refund check to the trustee in the amount of $15,532,440.39 for tax year 2013 (the "2013 Refund").³ The IRS contends that this check was sent in error.

In April 2017, the IRS issued four Notices of Proposed Adjustment ("NOPA"s) related to the 2013 Original Return. The NOPAs: (a) disallowed claimed advertising expenses in the amount of $2,151,645,140; (b) disallowed claimed commission expenses of $622,588,035; (c) disallowed the claimed Ympactus bad debt write-off of $186,344,898; and (d) imposed a failure-to-file penalty of $75,126,857.

In March 2018, the trustee filed an amended federal income tax return for 2013 (the "2013 Amended Return") reporting a taxable loss of $3,143,851.

5. 2014 Tax Returns

In June 2017, the trustee filed TelexFree's federal income tax return for 2014 (the "2014 Original Return"). The return...