Constructive Trust

---

Donald Derrington, et al., Plaintiffs v. United States of America , Defendant.

U.S. District Court, West. Dist. Wash. , at Seattle ; C02-5257L, September 12, 2003 .

[ Code Secs. 6323 and 6871]

Collection: Tax liens: Validity and priority against third parties: Constructive trust. --

The IRS was entitled to levy upon funds held by a bankruptcy estate to satisfy a debtor's delinquent tax obligations. Because funds transferred into the bankruptcy estate by a third party as part of an investment plan were determined to be a loan, the debtor was deemed the owner of the transferred funds at the time of the levy. The third party's prior testimony and an examination of the agreement between the third party and the debtor indicated that the transaction constituted a loan. As such, the transferred funds were appropriately subject to an IRS levy. Moreover, the court rejected the third party's argument that a constructive trust arose on its behalf to protect the transferred funds from IRS levy. The court noted that the IRS levy preceded the event giving rise to the possible establishment of a constructive trust.

ORDER GRANTING MOTION FOR SUMMARY JUDGMENT

I. INTRODUCTION

LASNIK, District Judge: This matter comes before the Court on a motion for summary judgment (Dkt. # 15) filed by defendant United States of America ("the IRS"). The IRS seeks dismissal of claims for a refund filed by plaintiffs Donald Derrington, et al. (collectively, "Plaintiffs"). The Court grants the IRS's motion for the reasons set forth in this Order.

II. DISCUSSION

A. Background.

This suit centers upon the ownership of approximately $235,000 seized in 2000 by the IRS to collect income taxes, interest and penalties owed by G. Sloan Smith ("Smith"). The funds levied by the IRS were payable to Smith or his nominee, Plains Group Ltd. ("Plains Group"), due to claims Smith obtained against a bankruptcy estate with funds supplied by Plaintiffs. Plaintiffs argue that they owned the claims from which the funds were derived. The IRS contends that Smith acquired the claims with money loaned to him by Plaintiffs and therefore the IRS's liens against the claims trumps any interest Plaintiffs may have had in the claims. Discussion of a fairly complex set of transactions is necessary for resolution of this issue.

In the early 1990s, the IRS assessed Smith with federal income tax liabilities arising from his failure to pay taxes owed for several years. (Bedford Decl. ¶3). Pursuant to 26 U.S.C. §6321, statutory liens arose against Smith's property and rights to property for the tax liabilities. Id. ¶4. In November of 1993, the IRS recorded nominee liens against Plains Group. Id. ¶5; see also Bedford Decl. Exs. A-B (notices of federal tax lien).

In 1991, Wallace and Clarice Hall ("the Halls") and their entities entered bankruptcy proceedings in In re Wallace and Clarice Hall, Bankr. No. 91-09143, United States Bankruptcy Court, Western District of Washington . (Hankla Decl. Ex. A (Derrington Decl.) ¶2). The Halls held a fifty percent interest in the Mariner Village Mobile Home Park in Everett , Washington . Id.

Plaintiffs learned of an investment opportunity involving the Halls' bankruptcy through John Widmer, a mutual friend of Plaintiffs and the Halls. Id. ¶7. The plan called for Plaintiffs, along with other investors, to purchase the unsecured claims against the Halls' estate, seek to have the bankruptcy case dismissed, and then recoup the principal investment plus points and interest with income generated by the Halls' interest in Mariner Village . Id. ¶ ¶5, 12. Plaintiffs initially planned to use an individual named Tim Golden ("Golden") to raise the funds and implement the investment plan. Id. ¶5. Golden gave a presentation to Plaintiffs in which he used a term sheet that described a one-year loan to an unspecified borrower. Id. Ex. 2. The plan called for Plaintiffs to earn a thirty-three percent return on their investment: a fifteen percentage point origination fee and eighteen percent interest. Id.

Golden was unable to complete the deal. Id. ¶2. However, in April of 1994, the Plaintiffs met with Smith and the parties finalized a deal that was similar to that proposed by Golden. Id. ¶12. Plaintiff Donald Derrington described the plan as follows:

The deal with Plains Group was to be the same as the deal with Golden, that is, we were putting up half the money, that Sloan Smith or some other investor would be going in on the rest of the transaction, and that our investment was to be secured by Hall's 50% ownership in the Mariner Village manufactured home park. The thrust was also to get the bankruptcy dismissed, but that our investment was to be secured by Hall's 50% ownership of the Mariner Village manufactured home park. We were also going to receive a 15% loan fee and 18% interest. If the Halls ended up with Mariner Village , we were going to be paid out over time. If the Halls did not end up with Mariner Village , we would have the security of the funds to be paid out on the bankruptcy claims from the funds in the hands of the Hall bankruptcy trustee.

 

The net result was that among the investors we put $325,000, which we paid to Sloan Smith or Plains Group Ltd. about April 21, 1994 .

Id. ¶ ¶12-13.

Plaintiffs and Smith signed a document entitled "Agreement to Consolidate Loans and Negotiate Settlement" (the "Agreement"). Id. Ex. 3. The Agreement appears to have contemplated that the investors would loan funds directly to the Halls and that the Halls would use the proceeds to settle the claims against them. ¹ See id. at ¶4 ("All funds loaned to the Halls by the undersigned lenders shall be subject to the terms of a loan agreement between the Halls and the undersigned lenders and shall be secured by the Halls [sic] 50% ownership in Mariner Village Mobile Home Park."). However, the Halls did not sign the Agreement. ²

On April 21, 1994 , Plaintiffs deposited funds into a Plains Group bank account. Id. ¶13. Smith then used the funds to purchase claims against the Halls' bankruptcy estate. (Hankla Decl. Ex. C (Derrington Dep.) at 44). Derrington accompanied Smith while he negotiated the claim purchases. Id. The claims appear to have been acquired in the name of the Plains Group. (Hankla Decl. Ex. A ¶19).

Smith did not acquire all of the creditors' claims and the bankruptcy trustee remained in control of the estate. Id. ¶ ¶16-17. The Halls' fifty percent interest in Mariner Village was sold through the bankruptcy proceeding, and the investors were therefore limited to the claims for repayment of the investment. Id. On November 2, 1994 , unbeknownst to Plaintiffs, the bankruptcy trustee made an interim distribution on the claims acquired by the Plains Group in the amount of $373,848. Id. ¶22. The check distributing these funds was payable to Sloan Smith. (Hankla Decl. Ex. D).

Smith did not inform Plaintiffs that he had received this distribution. (Hankla Decl. Ex. A ¶22). Plaintiffs later learned of the distribution from bankruptcy court records and demanded an accounting from Smith. Id. ¶27. Smith informed Plaintiffs that he had reinvested the funds in other ventures. Id. Shortly thereafter Plaintiffs hired an attorney and initiated a lawsuit against Smith in the United States District Court for the District of Oregon. In deposition testimony taken in that litigation the Plaintiffs characterized the transaction as a loan to Smith or the Plains Group. See Hankla Decl. Ex. C (Derrington Dep.) at 46 (testifying that he though he was loaning money to Sloan Smith); Hankla Decl. Ex. B (Nortman Dep.) at 18-19 (testifying that he thought he was loaning money to Smith or the Plains Group); Hankla Decl. Ex. F (Halver Dep.) at 18 (testifying that he thought he was loaning money to the Plains Group). Plaintiffs obtained a judgment against Smith and the Plains Group by default. (Second Hankla Decl. Ex. F).

After the $373,848 distribution, approximately $235,000 remained due from the Halls' bankruptcy estate on the Plains Group claims. (Hankla Decl. Ex. I). Plaintiffs sued the bankruptcy trustee in an effort to prevent distribution of the remaining amount to Smith. Id. Prior to issuance of the default judgment against Smith in the Oregon litigation, Plaintiffs and the bankruptcy trustee reached an agreement whereby the trustee would deposit the remaining amount into Plaintiffs' attorney's trust account pending resolution of the Oregon litigation. Id. However, before the bankruptcy trustee transferred the funds to the trust account, the IRS issued a notice of levy to the trustee commanding him to pay the Plains Group property to the IRS for taxes owed by Smith. ( Bedford Decl. Ex. C). Plaintiffs and the IRS negotiated for several months regarding whether the IRS might release the levy and pursue its tax claim in the Oregon litigation. (Hankla Decl. Ex. I). Plaintiffs and the IRS were unable to reach an agreement, and Plaintiffs initiated a wrongful levy action against the IRS in this Court. (Hankla Decl. Ex. L). On June 14, 2000 , the Court dismissed that action as time-barred. (Hankla Decl. Ex. T).

In September of 2000 the IRS obtained the levied funds, amounting to $239,498.29. The levied funds paid all of Smith's outstanding tax liabilities with the exception of approximately $3,000 due for 1990. (Bedford Decl. ¶18). In April of 2001, Plaintiffs filed admin istrative claims with the IRS in an attempt to recover the money seized by the IRS. (Colvin Decl. Ex. L). The IRS denied Plaintiffs' claims. (Colvin Decl. Ex. M). Plaintiffs initiated this lawsuit on May 22, 2002 .



B. Summary Judgment Standard.

Summary judgment is proper if the moving party shows that "there is no genuine issue as to any material fact and that [it] is entitled to judgment as a matter of law." Fed. R. Civ. P. 56(c).

Once a defendant who is seeking summary judgment has demonstrated the absence of a genuine issue of fact as to one or more of the essential elements of the plaintiff's claims, the plaintiff must make an affirmative showing on all matters placed at issue by the motion as to which the plaintiff has the burden of proof at trial. Celotex Corp. v. Catrett, 477 U.S. 317, 323 (1986). In such a situation Fed. R. Civ. P. 56(e) "requires the nonmoving party to go beyond the pleadings and by her own affidavits, or by the `depositions, answers to interrogatories and admissions on file,' designate `specific facts showing that there is a genuine issue for trial."' Id. at 324 (quoting Fed. R. Civ. P. 56(e)); see also Matsushita Elec. Indus. Co., Ltd. v. Zenith Radio Corp., 475 U.S. 574, 586-87 (1986) ("When the moving party has carried its burden under Rule 56(c), its opponent must do more than simply show that there is some metaphysical doubt as to the material facts.").



C. Ownership of the Claims Against the Hall Bankruptcy Estate.

All parties agree that the ownership of the claims against the Hall bankruptcy estate is the key issue in this litigation. See Motion at 12 ("The instant refund suit turns on a property question: who owned the Plains Group claims against the Hall bankruptcy estate, Smith or plaintiffs? If Smith owned the claims, then the government's liens for taxes attached to them, the levy was proper, and this suit must be dismissed."); Response at 13 ("[T]he only issue in this case is who is the rightful owner of the funds levied upon by the IRS from the Halls' bankruptcy estate? If Smith owned the claims, then the Government's liens attached to that property and the levy was proper."). When levying funds "the IRS `steps into the taxpayer's shoes' ... [and] acquires whatever rights the taxpayer himself possesses." United States v. National Bank of Commerce [ 85-2 USTC ¶9482], 472 U.S. 713, 725 (1985) (internal citation omitted). "[S]tate law controls in determining the nature of the legal interest which the taxpayer had in the property." Id. at 722. Therefore, if under state law Smith owned the claims, the IRS properly stepped into Smith's shoes when it levied the funds payable for the claims.

In support of its argument that Smith owned the claims, the IRS cites the above-quoted deposition testimony given by Plaintiffs in the Oregon litigation in which each of the Plaintiffs testified that the transaction involved a loan to Smith or the Plains Group. Additionally, the IRS cites a letter plaintiff Nortman wrote to Smith regarding the "Loan to Plains Group Ltd/Plains Mgmt Ltd/Sloan Smith" in which Nortman discussed payment of all "principle [sic]/points/interest" due to the investors. (Hankla Decl. Ex. A. Ex. 5). Additionally, when the Halls sued the bankruptcy trustee, Plaintiffs' prior attorney wrote a letter to the Halls' attorney threatening Rule 11 sanctions. (Hankla Decl. Ex. J). In that letter Plaintiffs' attorney stated that his clients had "lent money to Plains Group." Id.

The IRS also notes that once it became apparent that if the investment constituted a loan to Smith or the Plains Group, Plaintiffs would not recover the funds levied the by IRS, Plaintiffs' prior attorney advised them not to refer to the transaction as a loan. For example, Plaintiffs' prior attorney advised his clients "never to say anything that undercuts our position that you owned and own the claim." (Hankla Decl. Ex. N). Plaintiffs' prior attorney also stated in a letter to Plaintiffs that if Plaintiffs ultimately were considered lenders to Smith or Plains Group, they could "[k]iss the $235,000 in Seattle goodbye." (Hankla Decl. Ex. O).

Plaintiffs argue that their prior testimony that the transaction constituted a loan to Smith or the Plains Group should be disregarded because they were inexperienced investors. See Response at 14 ("To an unsavvy investor, such as the Plaintiffs, an advance of money to an agent for him to purchase bankruptcy claims for the Plaintiffs may have the feel or color of a `loan;' however, this is clearly not a `loan' in the legal sense."). Additionally, Plaintiffs attempt to explain their prior testimony by stating that reference to "`loaning' the investment funds to Smith ... was their short-hand way of describing the investment they made through Smith." Id. at 15 (emphasis in original) (citing Derrington Decl. Ex. D; Nortman Decl Ex. C; Colvin Decl. Ex. O). Finally, Plaintiffs submit a purported transcript of a telephone conversation in which Plaintiffs contend that Smith stated that the transaction did not constitute a loan to him. ³ See Colvin Decl. Ex. F at 6.

Having considered the evidence in the light most favorable to Plaintiffs, the Court finds that the transaction constituted a loan by Plaintiffs to Smith or the Plains Group. Not only is this demonstrated by Plaintiffs' prior testimony, but examination of the terms of the agreement, admitted by all parties, shows that Plaintiffs loaned the funds to Smith or the Plains Group and did not own the claims in the Hall bankruptcy estate. For example, Plaintiffs admit that the terms of the investment called for a thirty-three percent return on investment: a fifteen percentage point origination fee and eighteen percent in interest. See, e.g., Hankla Decl. Ex. A (Derrington Decl.) Ex. 2 (original terms sheet); Hankla Decl. Ex. A (Derrington stating that "[w]e were also going to receive a 15% loan fee and 18% interest). Plaintiffs maintained that this was their expected return even after they denied the transaction was a loan. See, e.g., Hankla Decl. Ex. R ( March 30, 2000 Nortman Dep.) at 19 (testifying that the agreement with Smith called for a return composed of a fifteen point fee and eighteen percent interest). The undisputed terms of the investment demonstrate that Plaintiffs did not contemplate an equity investment, in which they would assume the risk that the claims would not cover the funds they advanced (or the chance that the claims would be worth more than their principal and expected return). Furthermore, Plaintiffs' recent redefinition of the transaction as an "investment," rather than a "loan," does not support Plaintiffs' position. A loan is a particular kind of investment; the most common is known as a "bond."

The evidence before the Court demonstrates that Plaintiffs' investment constituted a purchase money loan to Mr. Smith. Plaintiffs did not own the claims levied by the IRS.



D. Constructive Trust.

Plaintiffs contend that even if the Court determines that they did not own the claims, the Court should find that a constructive trust in their favor arose prior to the time the IRS liens attached to the property. (Response at 16-18). In support of this argument Plaintiffs cite F.T.C. v. Crittenden, 823 F.Supp. 699 (C.D. Cal. 1993). Relying upon California law that a constructive trust may exist if a court finds "merely that the acquisition of property was wrongful and that the keeping of the property ... would constitute unjust enrichment," the Crittenden Court imposed a constructive trust retroactively to prime a federal tax lien. Crittenden, 823 F.Supp. at 703. Because the funds were wrongfully taken from consumers when the taxpayer secretly overcharged them, by virtue of the constructive trust "the funds ... belong[ed] to Crittenden's injured customers, and not to Crittenden." Id.

In Washington "[a] constructive trust arises where a person holding title to property is subject to an equitable duty to convey it to another on the ground that he would be unjustly enriched if he were permitted to retain it." Baker v. Leonard, 120 Wn. 2d 538, 547-48 (1993). Here, in contrast to Crittenden ⁴ , assuming that a constructive trust arose on Plaintiffs' behalf, such a trust could not have been formed prior to the time the IRS liens attached to the property. The parties do not dispute that Plaintiffs intended Smith and the Plains Group to utilize Plaintiffs' funds to acquire the creditors' claims. Smith could not have breached his duty to convey the proceeds of those claims to Plaintiffs until he failed to transfer to Plaintiffs the $373,848 interim distribution on November 2, 1994 . ⁵ Because the IRS liens attached to the claims when they were purchased by Smith/the Plains Group, any constructive trust on Plaintiffs' behalf would have been inchoate when the tax liens attached and therefore would not prime the liens. Blachy v. Butcher [ 2000-2 USTC ¶50,629], 221 F.3d 896, 906 (6th Cir. 2000).

III. CONCLUSION

For the foregoing reasons, the Court GRANTS the IRS's motion for summary judgment (Dkt. # 15). The Clerk of the Court is directed to enter judgment in favor of the IRS and against Plaintiffs. The Clerk of the Court is also directed to send copies of this Order to all counsel of record.

¹ Plaintiffs state that "at least on paper, the investors actually entered into an agreement with the Halls in which the investors would loan money to the Halls and the Halls agreed to pay points and interest." (Response at 4). However, Plaintiffs admit that this was not "the deal contemplated by the investors." Id. at 5.

² Additionally, it is unlikely that the Halls could have used such loan proceeds to pay off creditors because at the time the Agreement was signed the Halls were in bankruptcy proceedings.

³ Because the statement is made by a person other than the declarant to prove the truth of the matter asserted, the transcript constitutes inadmissable hearsay evidence. Fed. R. Evid. 801, 802. A party may not defeat a motion for summary judgment on the basis of inadmissible hearsay evidence. Orr v. Bank of America , NT & SA, 285 F.3d 764, 783 (9th Cir. 2002). Additionally, even if this transcript did not constitute inadmissible hearsay evidence, it would not likely assist Plaintiffs because Smith appeared to be speculating regarding what Hall's attorneys would consider the transaction to be based upon the written agreement. See Colvin Decl. Ex. F at 6 ( "I mean she faxed all the stuff down to her attorney's [sic] yesterday and those guys got it all and they're saying what the hell is this? This loan was made to Clarise [Hall], this wasn't made to Sloan Smith. Sloan Smith is the facilitator, he's the guy who's managing it. There's no loan to Sloan Smith.").

⁴ In Crittenden the constructive trust arose at the time the taxpayer secretly overcharged the customers.

⁵ Plaintiffs contend that "a constructive trust arose when Smith wrongfully purchased the claims in the name of Plains Management, Ltd. (not the Plains Group) for his own purposes, and intended to keep the proceeds for himself." (Response at 17). However, the parties do not dispute that Smith acquired the claims through the Plains Group, subsequently transferred them to Plains Management, and finally transferred them back to the Plains Group. See, e.g., Hankla Decl. Ex. A ¶ ¶14, 19 (Smith and Derrington acquired claims from funds in "Plains Group Ltd." account and "another entity called Plains Management was assigned the claims"); Hankla Decl. Ex. L (wrongful levy complaint) ¶15 ( "Eventually, Smith caused Plains Group Ltd. to assign the claims to defendant Plains Management (USA) Ltd., or Plains Management Ltd. Thereafter, Smith caused Plains Management (USA) Ltd., or Plains Management Ltd. to reassign the claims to Plains Group Ltd."). Even if a constructive trust arose when the claims were assigned from the Plains Group to Plains Management, the trust would have been inchoate when the tax liens attached and therefore would not prime the IRS liens. Blachy v. Butcher [ 2000-2 USTC ¶50,629], 221 F.3d 896, 906 (6th Cir. 2000).

 

 

Merchants Bonding Co., Plaintiff v. Utica Community Schools , West Bloomfield School District , and United States Internal Revenue Service, Defendants.

U.S. District Court, East. Dist. Mich. ; 01-60194, May 2, 2003 .

[ Code Sec. 6323]

Tax liens: Validity and priority against third parties: Constructive trust. --

A third-party subrogee was not entitled to summary judgment with respect to its claim of priority interest over an IRS tax lien for funds held by its subcontractor. The funds were property of the subcontractor and were not held in trust pursuant to a public construction contract under state ( Michigan ) law. A constructive trust had not been created to hold the funds because the subrogee failed to show that the parties intended to designate the funds as trust property, even though the bond identified the payment obligation to the subrogee under the construction contract. Finally, at the time the IRS filed its notices of tax liens, the subrogee's alleged equitable lien had not been perfected because the amounts in question were not certain.

[ Code Sec. 6323]

Tax liens: Validity and priority against third parties: Indemnity agreement: Surety's interest. --

A third-party subrogee was not entitled to summary judgment with respect to its claim of priority interest over an IRS tax lien for funds held by its subcontractor. The subrogee failed to show that an indemnity agreement with the subcontractor predated the IRS tax lien and, as a result, established its priority over the funds. The assignment of the contract balances under the indemnity agreement would not occur until the subrogee became obligated to perform under its surety agreement, the date of which had not been determined. Moreover, a genuine issue of material fact remained concerning whether the subrogee was required under state ( Michigan ) law to perfect its interest by recording its lien.

[ Code Sec. 6323]

Tax liens: Validity and priority against third parties: Security interest: Obligatory disbursement agreement. --

A third-party subrogee was not entitled to summary judgment with respect to its claim of priority interest over an IRS tax lien for funds held by its subcontractor. The court rejected the subrogee's argument that its security interest qualified as an obligatory disbursement agreement pursuant to Code Sec. 6323(c)(1)(B). Even though the bonds issued for the contract qualified as security interests, the subrogee failed to show that its security interest was protected under local law. Also, a genuine issue of material fact remained concerning when the subrogee's rights were triggered under the bonds, and if that date predated the IRS's tax lien.

OPINION AND ORDER OF THE COURT DENYING PLAINTIFF'S MOTION FOR SUMMARY JUDGMENT

I. INTRODUCTION

BATTANI, Judge: Before the Court is Plaintiff Merchants Bonding Co.'s Motion for Summary Judgment on its complaint against Defendants United States Internal Revenue Service ("IRS"), West Bloomfield School District ("WB") and Utica Community Schools. Plaintiff and the IRS both assert claims to the outstanding balances of two construction contracts ("contract balances" or "funds") between Smelser Roofing Co. ("Smelser"), a contractor, and Defendant school districts. Plaintiff claims that it is entitled to the funds since it made payments to various subcontractors and suppliers pursuant to the terms of its surety agreement with Smelser, while the IRS asserts the priority of its federal tax lien on Smelser's property.

As preliminary matter, Defendant WB has been dismissed as a party to this lawsuit, and has interpleaded into Court the amount due on its contract with Smelser, or $91,947.56, pursuant to Fed.R.Civ.P. 67, for disbursal to the proper party when this matter is resolved. Defendant Utica has filed an answer and partial concurrence in Plaintiff's motion for summary judgment, except to the extent to which Plaintiff's motion seeks interests, costs, expenses and attorneys fees against Utica . Utica still has in its possession the amount due on its contract with Smelser.

In its Motion for Summary Judgment, Plaintiff first argues that the contract balances are not Smelser's "property" subject to federal tax liens, since they have been held in trust for the benefit of the subcontractors and suppliers who performed work on the construction contracts. In connection with that argument, Plaintiff also asserts that its rights have been equitably subrogated to the rights of these subcontractors and suppliers, and therefore, that it can assert any claim to the trust corpus that they may have had. Second, Plaintiff argues that it received a superior interest in the funds pursuant to the Indemnity Agreement it entered into with Smelser, and that this interest became effective prior to the IRS' tax lien. Finally, Plaintiff asserts that 26 U.S.C. §6323(c) grants Plaintiff a lien superior to several of the liens held by the IRS.

In response, Defendant IRS argues that the Sixth Circuit's opinion in In re Constr. Alternatives, Inc. [ 93-2 USTC ¶50,569], 2 F.3d 670 (6th Cir. 1993) controls the Court's analysis here. In reliance upon this case, the IRS maintains that the contract balances are "property" subject to the tax lien, since Smelser completed the construction projects, and earned the right to final payment from Defendant school districts. Second, Defendant argues that no trust was created for the benefit of unpaid claimants because the Indemnity Agreement and Payment Bonds do not reflect the parties' intent to reserve a specific portion of the funds in trust for the benefit of any ascertained beneficiaries, Third, Defendant contends that Plaintiff's rights were not subrogated to the rights of the subcontractors and suppliers because at the time the IRS filed its tax liens, the amounts owed to those suppliers and subcontractors had not been determined to any meaningful degree of certainty. Fourth, Defendant contests Plaintiff's assertion that it had a "security interest" in the funds, but argues, that even if it did, it did not "perfect" that interest by filing a financing statement with the Michigan Secretary of State. Therefore, because the IRS did "perfect" its lien by filing notices of tax liens, its interest takes priority over that of Plaintiff. For these same reasons, Defendant maintains that Plaintiff's argument under §6323(c) also fails.



II. STANDARD OF REVIEW

F.R.C.P. 56 states that summary judgment "shall be rendered forthwith if the pleadings, [ etc.,] show that there is no genuine issue as to any material fact and that the moving party is entitled to a judgment as a matter of law." Fed.R.Civ.P. 56. There is no genuine issue of material fact if there is no factual dispute that could affect the legal outcome on the issue. Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 248-49 (1986). In other words, the movant must show that it would prevail on the issue even if all factual disputes are conceded to the non-movant. Additionally, for the purposes of deciding on a motion for summary judgment, a court must draw all inferences from those facts in the light most favorable to the non-movant. Matsushita Elec. Indus. Co. v. Zenith Radio Corp., 475 U.S. 574, 587 (1986).

Accordingly, in the instant case, the Court evaluates this motion with the rule that it should defer to Defendant's factual account whenever that account clashes with Judgment, Plaintiff asserts three separate grounds for its claim to the funds, and each will be discussed accordingly.

1. Equitable Subrogation and the Trust Theory

Plaintiff begins its argument by claiming its status as an equitable subrogee. Equitable subrogation is a "legal fiction through which a person who pays a debt for which another is primarily responsible is substituted or subrogated to all the rights and remedies of the other." Commercial Union Ins. Co. v. Med. Protective Co., 426 Mich. 109, 117 (1986). Merchants, having paid the claim of its principal, asserts that it is subrogated to the rights of the principal, the claimant receiving the payment, and the owner's right to withhold contract balances. The Court agrees that Plaintiff is, by a fiction of law, subrogated to whatever rights the claimant, principal, or owner may have in the contract balances, Pearlman v. Reliance Ins. Co., 371 U.S. 132 (1962).

Plainitff seeks here to enforce its claim to the contract balances owed by WB and Utica as the subrogee of the Claimants. Those funds, according to Plaintiff, were the trust corpus held for the benefit of the unpaid subcontractors and suppliers --the Claimants. As trust fund money, Smelser did not have a property interest in it. Therefore, the IRS could not attach its lien.

In response, Defendant IRS asserts two grounds for its argument that Smelser had a property interest in the funds. First, the IRS argues that, according to Construction Alternatives, once a contractor completes work on a construction contract, as Smelser did here, it earns the right to receive payment. It is that right to receive payment that constitutes a property interest to which a tax lien may legally attach. Constr. Alternatives [ 93-2 USTC ¶50,569], 2 F.3d at 674-65. Second, the IRS asserts that the contract balances are not a separate trust fund, because the parties did not create such a trust for the benefit of any subcontractors or suppliers. In light of this, then, the IRS maintains that Plaintiff was not a subrogee of the rights of the so-called "trustees." Finally, the IRS argues that, in any event, a state law subrogation claim does not become perfected until the amounts owed to the claimants are determined with certainty. Here, the amounts owed to the claimants were uncertain at the time the IRS filed its federal tax liens, and, so, the claims were not perfected.

In determining whether or not Smelser had an interest in the funds, the Court's analysis is twofold. Setting aside Plaintiff's "trust" argument for the moment, the Court must first decide whether Smelser acquired an interest in the funds when it completed its work on the WB and Utica projects. The Court finds that it did. Construction Alternatives holds that once a contractor completes work on a construction contract, its "right to receive its final progress payment ..." is deemed "property" under §6321, and can be subject to a federal tax lien. Id. Here, then, since the parties agree that Smelser completed its work on the WB and Utica construction projects, its right to receive final payment from the school districts is property that can be subject to the IRS tax lien.

This does not end the Court's inquiry, however, for it must now decide whether the contract balances were held in trust for the benefit of unpaid subcontractors and suppliers, leaving Smelser with no property interest in the funds. To prove that the funds at issue here were held in trust, Plaintiff must show either that: "1) [state] law provides that a portion of the progress payments were subject to a constructive trust for the benefit of unpaid suppliers and subcontractors ¹ ; or, 2) the suretyship agreement created an express trust with the Fund as the trust corpus." Constr. Alternatives [ 93-2 USTC ¶50,569], 2 F.3d at 677.

First, when a public construction contract is involved, as is the case here, Michigan law does not provide that a portion of an owner's payments are to be held in trust for the benefit of unpaid suppliers and subcontractors. The Michigan Building Contract Fund Act, Mich. Comp. L. 570.151 et. seq.,("MBCFA"), cited by Plaintiff, applies only to private construction contracts, and provides that, when such contracts are involved, balances paid to a contractor are to be held in trust for the benefit of subcontractors and suppliers. See In re Certified Question from U.S. Dist. Court for Eastern Dist. of Michigan, 311 N.W.2d 731, 733 ( Mich. 1981) (holding "the [MBCFA] applies only to private construction contracts.") Here, however, the contracts were public, not private; therefore, the MBCFA does not apply.

Since the MBFCA does not apply to create a constructive trust, the Court must look to the agreements. Plaintiff argues that Smelser, WB and Utica created a trust, with the contract balances serving as the trust corpus. To determine whether a trust was created, the Court looks to state law. Constr. Alternatives [ 93-2 USTC ¶50,569], 2 F.3d at 675. In Michigan , "it is a general principle of trust law that a trust is created only if the settlor manifests an intention to create a trust, and it is essential that there be an explicit declaration of trust accompanied by a transfer of property to one for the benefit of another." Osius v. Dingell, 134 N.W.2d 657, 660 ( Mich. 1965). Further, "[t]o create a trust, there must be an assignment of designated property to a trustee with the intention of passing title thereto, to hold for the benefit of others. There must be a separation of the legal estate from the beneficial enjoyments..." In re Americana Found., 387 N.W.2d 586, 588 (Mich. App. 1985) (quotation omitted).

Here, Plaintiff argues that the language of the payment bonds issued for the WB and Utica projects created an express trust for the benefit of subcontractors and suppliers. Specifically, Plaintiff notes that paragraph 8 of the payment bonds states as follows:

[a]mounts owed by the owners to the contractor under the construction contract shall be used for the performance of the construction contract and to satisfy claims, in any, under any construction performance bond. By the contractor furnishing and the owner accepting this bond, they agree that all funds earned by the contractor in the performance of the construction contract are dedicated to satisfy obligations of the contractor and the surety under this bond ..." (emphasis added)

Clearly, the bond at issue here identified Smelser's payment obligations with respect to the monies received from WB and Utica under the construction contracts. However, this language, by itself, does not establish that Smelser, WB and Utica created a trust in favor of the subcontractors and suppliers. Rather, as discussed above, to establish that a trust existed, Plaintiff must show that the parties involved intended to create a trust, and that they designated certain funds as trust property. Osius, 134 N.W.2d at 660; In re Americana Found., 387 N.W.2d at 588. The Court finds that this is not established here.

To begin, it is arguable that the use of the word "dedicated" in the payment bond signifies an intention or declaration on the part of Smelser, WB and Utica to create a trust for the benefit of the subcontractors and suppliers. Nevertheless, regardless of whether this language manifested such intent, Plaintiff's argument fails because none of the parties involved delivered any funds into trust in accordance with Michigan law. That is, the facts do not establish that the parties involved intended to set aside a certain portion of the funds "in trust" for the subcontractors or suppliers, and, in fact, at no time did Smelser create a separate trust account for the contract balances. The mere fact that Smelser earned the right to receive payment for the school projects by completing its construction work does not, by itself, make the money owed by WB and Utica trust property.

The Court's analysis is guided, in part, by Construction Alternatives, where the Sixth Circuit held that the language of an Indemnity Agreement between a surety and a contractor did not create a trust under Ohio Law. There, the Indemnity Agreement stated that "all monies due .. are trust funds, for the benefit of and for payment of all such obligations in connection with any such contract ... for which the Surety would be liable under any of the ... bonds..." Constr. Alternatives [ 93-2 USTC ¶50,569], 2 F.3d at 676, n. 4. The Ohio law applied by the Sixth Circuit was very similar to Michigan law, and provided that "the manifested intention" of the parties governed whether or not the parties had created a trust.

In deciding whether a trust had been created in Construction Alternatives, the Sixth Circuit examined whether the parties intended that the money be kept or used as a separate fund for the benefit of third persons. Id. at 677 (quoting Guardian Trust Co. v. Kirby, 50 Ohio App. 539 (1935)). Ultimately, the Court concluded that despite the actual "trust" language contained in the Indemnity Agreement, no trust was created, because "no provision of [the indemnity agreement] required [the contractor] to keep any portion of the progress payments as a separate trust fund, and the record does not indicate that [the contractor] kept the progress payments in a separate account." Id. at 677. Similarly, here, because the language of the payment bond did not require Semlser to set aside a portion of the payments in a separate trust fund, no trust was created.

In light of this, Plaintiff's subrogation claim to a trust fund fails. This does not mean, however, that Plaintiff is not an equitable subrogee, for, as noted above, in paying Smelser's claims, Plaintiff became subrogated to whatever rights those claimants had in the contract balances, Pearlman v. Reliance Ins. Co., 371 U.S. 132 (1962). Consequently, as an equitable subrogee, Plaintiff must establish that its right to the funds takes priority over the IRS's tax lien.

Federal liens do not "automatically have priority over all other liens." Constr. Alternatives [ 93-2 USTC ¶50,569], 2 F.3d at 676 (quotations omitted). Rather, they are subject to the "first in time, first in right" rule. Id. For purposes of this rule, a federal tax lien is perfected at the time the notice of the lien is filed, Constr. Alternatives [ 93-2 USTC ¶50,569], 2 F.3d at 676 (citations omitted), while a state lien is perfected only "when the identity of the lienor, the property subject to the lien, and the amount of the lien are established." United States v. Dishman Indep. Oil Co. [ 99-2 USTC ¶50,992], 46 F.3d 523, 526 (6th Cir. 1995) (quoting United States v. McDermott [ 93-1 USTC ¶50,164], 507 U.S. 447, 449 (1993)). In the context of equitable subrogation, the Sixth Circuit held in Construction Alternatives that a surety's alleged equitable lien did not have priority because "[t]he amounts owed to the unpaid persons on the project were not yet certain" at the time the tax liens were filed. Constr. Alternatives [ 93-2 USTC ¶50,569], 2 F.3d at 676.

Here, the IRS filed its notices of tax lien on August 30, 2000 , January 2, 2001 , May 21, 2001 and June 27, 2001 . Plaintiff, however, has not established that its alleged equitable lien was perfected as of those dates, because it has not shown that the amounts owed to the unpaid subcontractors and suppliers were certain at that time. In fact, the record does not contain any evidence as to the dates and amounts of Plaintiff's payments, or to whom those payments were made. As such, the Court finds that as an equitable subrogee, Plaintiff has not established the priority of its lien, because there is a genuine issue of material fact with respect to the payments Plaintiff made under its bond agreement with Smelser.

2. Indemnity Agreement Theory

Plaintiff next argues that the Indemnity Agreement it entered into with Smelser gave it a superior interest in the contract balances. In particular, Plaintiff points to the language of the Agreement in which Smelser agreed to assign and transfer its rights in the monies owed by WB and Utica to Plaintiff as "collateral security" for performance of the bond contract. According to Plaintiff, that assignment became effective as of the date of execution of any bond, or September 1, 1998 . And, since this preceded the dates upon which the IRS filed its notice of tax lien, Plaintiff contends that it's interest takes priority over the IRS lien.

In making this argument, Plaintiff acknowledges that, in most circumstances, parties are required by Article 9 of Michigan's Uniform Commercial Code to perfect their interests by filing financing statements with the Michigan Secretary of State. However, in reliance upon In Re V. Pangori Sons, Inc., 53 B.R. 711, 717 (Bankr. E.D. Mich. 1985), Plaintiff asserts that, in Michigan , Article 9 does not apply to indemnity agreements. In particular, Plaintiff relies on the language in Pangori that states that a surety may assert "its rights deriving from the agreement of indemnity because even though it did not take the steps necessary to perfect an Article 9 security interest, it did not need to do so." Id. This is so because "the assignment does not create a security interest" in the contract balances. Id. Therefore, Plaintiff maintains that it did not have to perfect its interest with the Secretary of State.

In response, the IRS counters that Plaintiff's claim to the funds is not superior to the IRS lien because Plaintiff was, in fact, required to perfect its interest by filing with the Secretary of State. In so arguing, Defendant asserts that Pangori, a 1985 bankruptcy case, was called into doubt by the Sixth Circuit's 1993 holding in Construction Alternatives, where an Ohio U.C.C. provision, identical to the Michigan statute relied upon by the Pangori court, was interpreted to require a bond company to perfect its interest by filing a financing statement with the Secretary of State. The IRS now asks this Court to extend the Sixth Circuit's holding to Michigan , and hold that, here, Plaintiff was required to file its Indemnity Agreement with the Secretary of State.

Defendant's argument is quite compelling. For, as Defendant points out, the relevant portion of the Michigan statute at issue in Pangori is precisely the same as the Ohio statute analyzed in Construction Alternatives. Both provisions provide that the UCC does not apply to "a transfer of a right to payment under a contract to an assignee who is also to do the performance under the contract...." Ohio Rev. Code Ann. §1309.04; Mich. Comp. Laws §19.9104. Thus, one could reasonably argue, as the IRS does here, that the Sixth Circuit's interpretation and application of the Ohio statute should carry over to Michigan to require Plaintiff to file its Indemnity Agreement with the Secretary of State.

The Court, however, declines to apply the holding in Construction Alternatives to Michigan . The Sixth Circuit did not have the opportunity to consider the issues raised in Pangori, even though it may have been applying similar law. It simply held in one cursory sentence that a financing statement would have to be filed. Pangori, on the other hand, contained a more detailed analysis of Article 9 and its relationship to indemnity agreements. See Pangori, 53 B.R. at 717. Therefore, the Court will not disturb the Pangori decision, and what may have been the Michigan practice since 1985, unless it is clearly required to do so.

The Court's analysis does not end here, because it is still necessary to determine when Plaintiff's interest in the funds became effective. According to Plaintiff, the express language of the Indemnity Agreement provided that Smelser's assignment of the contract balances became immediately effective as of the date of any bond, or September 1, 1998 , when the Fringe Benefit Bond was executed. In making this argument, Plaintiff relies on two Michigan cases, Pangori, discussed above, and Early Dubey & Sons v. Macomb Contracting, 97 Mich. App. 553 (1980). According to Plaintiff, the indemnity agreements at issue in those cases granted the plaintiffs assignment rights in construction funds. Unlike the Indemnity Agreement at issue here, however, those agreements provided that the operative date upon which the plaintiffs' assignment rights became effective was the date of the contractor's default. Here, according to Plaintiff, the Indemnity Agreement provided a different operative date, namely the date of the execution of any bond. Therefore, Plaintiff concludes that because the IRS did not have a lien on Smelser's property as of September 1, 1998 , when the Fringe Benefit Bond was executed, the IRS does not have a superior claim to the funds.

The Court duly notes Plaintiff's argument, but finds that neither Pangori nor Dubey stand for the proposition advanced by Plaintiff that the language of the Indemnity Agreement governs the date upon which a surety's assignment rights become effective. First, in Pangori, the indemnity agreement contained language similar to the Indemnity Agreement here; in particular, it stated that the assignment was to "be effective as of the date of [a] bond or bonds..." Id. at 716. However, unlike the Indemnity Agreement in this case, the Pangori agreement contained additional language indicating that the surety's assignment rights did not become effective until "the event of default..." Id. Ultimately, the surety's claim was held to be inferior to the judgment lien creditor's competing claim, and the court did hold, as Plaintiff asserts, that the relevant date for analyzing the priority of the surety's claim was the date of the contractor's default.

Contrary to Plaintiff's assertion, however, the Pangori court did not seem to rest its decision on the language contained in the indemnity agreement. Rather, the court looked to Michigan law, which essentially dictated that a surety's claim did not become effective until the surety became obligated to pay under its bond agreement with the contractor. Specifically, the Pangori court held that:

Michigan law holds that a lien of a judicial lien creditor which attaches before a surety becomes obligated to perform under its bond is prior in right to the surety's claim. Thus, the rights of subrogation and indemnification are not permitted to relate back to the date of the initial suretyship agreement when a judicial lien intervenes. Accordingly, because [the surety's] claim to the proceeds by virtue of its contractual indemnity agreement is inferior to the rights of the [bankruptcy] trustee, it may thus be avoided.

Pangori, 53 B.R. at 721.

Similarly, in Dubey, the Michigan Court of Appeals found that the operative date upon which the surety's assignment rights became effective was the date of the contractor's default. Unlike Pangori, however, the Dubey court relied more heavily upon the language of the indemnity agreement, which also provided that the surety's assignment rights would "be effective as of the date of any such bond, but only in the event of a default..." Specifically, the Dubey court noted that "it is ... clear from the contractual language that default, requiring completion of the project at [the surety's] expense, triggers [the surety's] right to claim, by assignment, [the contractor's] rights to the [construction] funds..." Dubey, 97 Mich. App. at 558. Thus, according to Dubey, the surety's assignment rights were triggered as of the date of the contractor's default, and those rights related back to the date of execution of any payment and performance bonds. Id. at 559.

A careful review of the Dubey opinion reveals that, when rendering its decision, the Michigan Court of Appeals did not rely entirely on the language of the indemnity agreement, but rather, paid considerable attention to the same Michigan law that governed the court in the Pangori decision. In particular, the court noted that:

[a] number of cases ... impel the conclusion that [defendant surety], as performance bond surety, had no contractual rights to the funds ... because as of the date of plaintiff's writ of garnishment, [the surety] was not obligated to perform under its surety contract. [I]f in fact, [the surety] had become so obligated, then either under the terms of its indemnification agreement with [the contractor] or under equitable subrogation principles its rights would be superior to plaintiffs'.

Of particular importance to the Michigan Court of Appeals was the overarching principle that "[i]n order for a surety to prevail over competing creditors it is necessary that the contractor be in default as a matter of fact, and that the surety be obligated under its bond to perform..." Id. at 559-60.

Therefore, what appears to have guided the courts in Dubey and Pangori was not the language contained in the indemnity agreements itself, but rather, the well-founded principle that a surety's assignment rights are triggered upon the contractor's default. In fact, this is quite understandable given that a surety does not need to enforce its assignment rights unless and until it is obligated to perform under its agreement with the contractor; i.e., when the contractor defaults on its own payment responsibilities.

Here, the Indemnity Agreement stated that Smelser assigned the right to the contract balances to Plaintiff "as of the date of execution of any Bond..." The Court disagrees with Plaintiff's assertion that, for purposes of assessing priority, its claim to those funds became effective as of September 1, 1998 , or the date it issued the Fringe Benefit Bond. Rather, in light of the rule of law stated in both Dubey and Pangori, Plaintiff's assignment rights were triggered when it became obligated to perform under its surety agreement. This is so despite the fact that the Indemnity Agreement did not contain any specific "default" language. For, the Court notes while not explicitly stated, it was implicit in the Indemnity Agreement that Smelser's assignment of the contract balances would occur only when Smelser defaulted. Therefore, the Court finds that Plaintiff's claim to the funds was not effective as of the date Plaintiff executed the Fringe Benefit Bond, but rather, as of date of Smelser's default. Since the facts are unclear as to when this occurred, the Court finds that Summary Judgment in Plaintiff's favor is inappropriate at this time.

3. Statutory Theory

Lastly, Plaintiff argues that in the event that the Court finds that Plaintiff is not entitled to all of the funds at issue here, it should still receive a portion of the contract balances pursuant to 26 U.S.C. §6323(c). This provision provides, in pertinent part, as follows:

(1) In General. To the extent provided in this subsection, even though notice of a lien imposed by §6321 has been filed, such lien shall not be valid with respect to a security interest which came into existence after tax lien filing but which --

 

(A) Is in qualified property covered by the terms of a written agreement entered into before tax lien filing and constituting --

 

...

 

(iii) an Obligatory Disbursement Agreement, and

 

(B) is protected under local law against a judgment lien arising, as of the time of tax lien filing, out of an unsecured obligation.

According to Plaintiff, the fringe benefit bond issued on September 1, 1998 , and subsequent payment bonds issued in November and December, 2000, qualified as security interests within the meaning of the statute in that they were "obligatory disbursement agreements." Furthermore, with respect to 26 U.S.C. §6323(c)(1)(B), Plaintiff argues that "a surety's right of equitable subrogation defeats a judgment lien, and therefore satisfies the second prong of the ... statute." Thus, according to Plaintiff, it should be reimbursed, at the very least, for the amounts it paid on those bonds, or approximately $177,000.

In response, Defendant argues that Plaintiff did not have a "security interest" within the meaning of the statute, and therefore, cannot assert priority based on §6323(c). In particular, Defendant argues that the contract between Plaintiff and Smelser was not an "obligatory disbursement agreement," and more importantly, that Plaintiff's interest was not protected under local law, since Plaintiff did not file its Indemnity Agreement with the Secretary of State.

First, an "obligatory disbursement agreement" is "an agreement (entered into by a person in the course of his trade or business) to make disbursements, but such an agreement shall be treated as coming within the term only to the extent of disbursements which are required to be made by reason of the intervention of the rights of a person other than the taxpayer." 26 U.S.C. §6323(c)(4)(A). According to Amwest Sur. Ins. Co. v. United States [ 94-2 USTC ¶50,558], 870 F.Supp. 432, 434 (D. Conn. 1994), a surety bond constitutes an obligatory disbursement agreement within the meaning of the statute. Therefore, the Court agrees with Plaintiff that the bonds issued for the construction contracts are covered by the first prong of §6323(c).

With respect to the second prong, the Court finds that Plaintiff has failed to establish that its security interest was "protected under local law" as required by §6323(c)(1)(B). However, in so holding, the Court does not endorse Defendant's assertion that, in order to protect its interest under local law, Plaintiff was required to file its Indemnity Agreement with the Secretary of State. For the reasons discussed above, Plaintiff was not subject to the filing requirements of Article 9. Pangori, 53 B.R. at 717.

Plaintiff argues that it's interest was "protected under local law" because it became equitably subrogated to the rights of potential unpaid claimants on the dates it issued the bonds for the school projects. In so arguing, Plaintiff relies on Amwest, which provides that "[i]f the conditions of [ §6323(c)] are met, a surety's interest in contract proceeds pursuant to a bond executed before a tax lien is filed, will prevail over the lien even if the surety payments are made after liens are filed." Amwest [ 94-2 USTC ¶50,558], 870 F.Supp. at 434 (citations omitted). Accordingly, Plaintiff argues that regardless of when it was actually called upon to make surety payments on its bonds, its claim to the funds is superior to Defendant's because it executed some of those bonds prior to the IRS liens.

The Court agrees with Plaintiff that in Amwest the court held that the surety's interest accrued on the date it executed the bond, not the date upon which it paid the contractor's outstanding debts to the unpaid subcontractors and suppliers. With that said, however, the Court notes that the Amwest decision is based on Connecticut , not Michigan , law, and therefore, does not control this Court's analysis.

Notably, in Amwest, the court's decision was based on Connecticut 's endorsement of the relation back doctrine, which dictates that a surety's equitable subrogation rights relate back to the date of the bond. Amwest [ 94-2 USTC ¶50,558], 870 F.Supp. at 435. ² Michigan , however, has not adopted the relation back doctrine as it relates to a surety's equitable subrogation rights. Rather, in Michigan , "the right to subrogation accrues upon payment of the debt." Dubey, 296 N.W.2d at 585. Therefore, "[i]n order for the surety to prevail over competing creditors it is necessary that the contractor be in default as a matter of fact, and that the surety be obligated under its bond to perform..." Id.

In Pangori, which Plaintiff relied on in the previous issue, the Court, when analyzing the surety's equitable subrogation claim, applied the Michigan Court of Appeals' holding in Dubey and found that "[i]n Michigan, as long as the surety's liability is contingent and has not become an actual obligation triggered by its principal's default, its equitable rights may be subordinated to an intervening judicial lien creditor." Pangori, 53 B.R. at 719. Therefore, the Pangori court held, "[t]he court's conclusion in Dubey may be summarized as stating that two elements were necessary for the surety to prevail: first, it must show that there was an actual default prior to garnishment; second, it must show that it actually became obligated to pay." Id. at 719-20 (citing Dubey, 97