A recent opinion of the U.S. Court of Appeals for the Eleventh Circuit raises an interesting question under the law of negotiable instruments as it relates to the government’s ability to collect unpaid taxes. The defendant pled guilty to numerous counts of tax fraud and agreed to make restitution to the IRS for almost $400,000 in unpaid taxes. He was also sentenced to 20 months incarceration and four consecutive one-year terms of supervised release. Just before he was sentenced, the defendant sold the stock in a nightclub that he owned along with its liquor license to his father for $135,000. The father gave the defendant a promissory note for $135,000 to be paid in $1,300 installments. The trial court ordered the note to be transferred to the government with the payments on the note credited to the defendant’s restitution. The appellate court upheld the trial court’s decision on this point, noting that the Internal Revenue Code gave the government broad authority to collect on the restitution order.
But, the court’s decision raises the question of whether it can actually collect on the note. It’s a question that involves the law of negotiable instruments. Here’s the deal. Because of the court-ordered transfer of the note to the government, the government stepped into the shoes of the defendant and acquired the defendant’s rights in the note. What were the defendant’s rights in the note? That depends on whether the defendant was a “holder in due course” (HDC). An HDC is anyone that acquires a negotiable promissory note without knowledge of any claims or defenses associated with the note. The person making payments on a note held by an HDC generally cannot refuse to pay a third party due to defenses or claims that the third party may have against the original holder of the note. But, here’s the rub - the defendant committed fraud related to the note and was not an HDC. As a result, the government cannot qualify as an HDC either. As a result, the defendant’s fraud concerning the note would create a claim or defense to the note’s payment. That means that the defendant’s father (who is to make payment on the note) could raise the defense of fraud to rescind the note and recover the note or its proceeds. If that occurred, the government would have to argue that the defendant did not commit fraud in order for the government to collect on the note. But, how could the government possibly make that argument - the defendant has already been convicted of fraud. So, it looks like the government may not be able to collect on the note.
From a planning perspective (for persons charged with tax fraud) will the recommended course of action be to transfer assets to a third party in exchange for a promissory note with the goal of having the third party rescind or void the note and reclaim the note proceeds once the government gets possession of the note? One would think that the government would go after the third party for fraud and/or transferee liability. But, the court in this case, while opining that the transaction between the defendant and his father was fraudulent, noted that it couldn’t avoid the transaction because doing so would affect the father’s rights. That’s why the court ordered the note be transferred to the government.
This case raises lots of questions, and it certainly appears that neither the government nor the court thought through the issues involved. United States v. Spangler, No. 06-13881, 2007 U.S. App. LEXIS 6290 (11th Cir. Mar. 19, 2007).