Chapter 7 Brings an Opportunity to Use IRS Liens to Satisfy Unsecured Creditors

The Fifth Annual Tax Controversy Institute will be held online on July 17th.  This Institute is sponsored by the University of San Diego School of Law and the tax law firm of RJS Law.  Here is a link to further information about the Institute’s program and a place to sign up for virtual tickets.  The keynote speaker is Sharyn Fysk (Director of the IRS Office of Professional Responsibility), and the Institute is presenting an award to Professor Carr Ferguson acknowledging his lifetime of achievement in the tax field

The ABA Tax Section May meeting continues online.  Find information about the online program here.  It continues with two or three programs each week through the end of July.  Note that for readers of this blog many of the tax controversy programs from committees that focus on tax procedure occur toward the end of the program.  Here are some of those programs and the dates:  July 14  Civil & Criminal Tax Penalties – panel descriptions;  July 22  Court Procedure & Practice – panel descriptions;  July 29  Administrative Practice – panel descriptions; and  July 30  Standards of Tax Practice – panel descriptions.  You can purchase tickets to individuals committee sessions or to the overall meeting.


In the case of United States v. Hutchinson, 125 AFTR 2d 2020-1968, (EDCA 2020) the district court sustains the decision of the bankruptcy court avoiding portions of the IRS lien.  Based on the prior precedent in the circuit and the language of the statute, the outcome is not surprising.  The fact that the Department of Justice appealed the decision from the bankruptcy court suggests that it may press to take the matter further.  The outcome here results from Congressional efforts in the bankruptcy code to allow unsecured creditors to get paid before the IRS gets paid for a debtor’s bad acts.  Due to the timing of the filing of the federal tax liens at issue in this case and the IRS practice of paying down liabilities in the order of tax, penalty then interest, the IRS loses most of the value of its liens even though it had filed lien amounts for taxes exceeding the value of the equity.  A tough result for the IRS that the court could have explained better but a good result for creditors who might not have expected anything out of this bankruptcy case.

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 The case results from Congressional generosity in chapter 7 cases in order to provide something for the unsecured creditors.  A very high percentage of chapter 7 cases are “no asset” cases meaning that unsecured creditors get nothing.  Here, the trustee uses the IRS lien and the front-end loading of the penalties owed on the liabilities reflected in the lien to reach a favorable result for the unsecured creditors.

At the time of the filing of the bankruptcy, the IRS had the following liabilities owed to it for which it had filed a notice of federal tax lien:

Recording DateTaxInterest on TaxPenalty
05/23/2011$0.00$6,450.15$44,500.11
05/23/2011$62,913.27$17,794.31$87,599.43
07/25/2011$40,436.77$11,403.79$30,549.31
06/14/2016$67,050.11$4,938.42$42.00
06/14/2016$36,337.67$2,052.10$0.00
Total:$206,737.82$42,638.77$162,690.85

Bankruptcy Code section 724(a) provides “(a) The trustee may avoid a lien that secures a claim of a kind specified in section 726(a)(4) of this title.”  Section 726(a)(4) provides “fourth, in payment of any allowed claim, whether secured or unsecured, for any fine, penalty, or forfeiture, or for multiple, exemplary, or punitive damages, arising before the earlier of the order for relief or the appointment of a trustee, to the extent that such fine, penalty, forfeiture, or damages are not compensation for actual pecuniary loss suffered by the holder of such claim;”

The combination of these two sections allows the trustee to avoid a federal tax lien securing a penalty.  No one in the case disputed this result.  At issue in Hutchinson is the effect of avoiding the lien for the penalty.  The court stated that the issue in the case was “Whether the bankruptcy court erred in denying the government’s motion to abandon property of the bankruptcy estate based on the determination that avoided and preserved penalty portions of liens were not of inconsequential value to the estate.”

Later in the case the court stated the issue another way which perhaps provide more clarity regarding the actual dispute:

Here, the question is whether the tax and interest portions of the IRS’s five liens enjoy a higher priority over the penalty portions of the liens, despite each lien being comprised of tax, interest, and penalties at recordation. It appears that the law does not clearly delineate the extent to which certain categories of avoided and preserved liens might confer greater rights to the estate by operation of § 551, than rights the actual creditor would have held following avoidance of its lien. What priority do avoided penalty liens take? That is the question here.

The IRS filed a motion seeking a court order that the trustee abandon the property because the property was fully encumbered and would bring no value to the estate.  The taxpayer had property worth about $190,000.  A senior lien stood ahead of the IRS liens, leaving about $110-120,000 in value to which the federal tax liens attached.  As you can see from the values listed above in the chart regarding the IRS liens, the tax alone was over $200,000.  The IRS argued that because more tax was owed than the value of the equity, nothing existed for the trustee to administer.  The property should be jettisoned from the estate so that the IRS could go after the property to satisfy its lien interest.

Countering the IRS argument, the trustee said that because some of the lien was for penalties which the trustee could avoid, the avoidance should occur and the unsecured creditors should benefit from the avoidance. 

The statute provides no guidance regarding how the lien avoidance impacts the payment to the creditor.  The oldest liens get paid before the newer liens.  Looking at the oldest liens in the group of five, the amount of unpaid penalty on the older liens is substantial.  The trustee argues that he should approach the first lien and avoid the penalty amount of that lien.  This would put $44,500.11 into the pot for the unsecured creditors.  Then the trustee should go to the next lien and create a pro rata basis for treating that lien up to the value of the equity in the property.  If the first lien for a total of $51,950.26 eats into that much of the equity in the property, there is approximately $65,000 in equity left as the trustee moves to the second lien.  The trustee can avoid a pro rata amount of the second lien based on the percentage of the lien attaching to equity and the percentage of the penalty to the overall amount due on the lien.  This allows the trustee to avoid another $-X- from the second oldest recorded notice of federal tax lien which will go to the unsecured creditors.

Because the court did not engage in exactly the process I have described, I cannot say for certain that this is what it has held but I believe this was the trustee argument with which the court agreed.  The court notes that there is little or no case law on this issue but cited to a pair of earlier cases involving the avoidance provisions of B.C. 724 to support its conclusion that the bankruptcy court got it right.

The IRS argues that because the tax due on its liens exceeds the amount of the equity, the property should be abandoned without going through a test like the one described above. 

Because the specific fact pattern described here occurs infrequently, DOJ and the IRS may decide not to appeal the decision.  I did not read the briefs filed by DOJ which would have allowed me to come to a better understanding of the government’s argument.  The basic concepts determined by the bankruptcy court and the district court seem correct to me even though it creates a harsh result for the IRS in this situation.  Congress decided in section 724 to sacrifice the liens of governmental entities for the benefit of unsecured creditors.  It did not specify how the avoidance of the penalty part of the liens would work vis a vis the tax on the liens.  Working the liens from oldest to newest also makes sense to me.  So, the outcome makes sense. 

The court goes into an explanation of the interplay of BC 551 with BC 724 to allow unsecured creditors to step into the shoes of liens secured by penalties.  BC 551 preserves the position of the IRS lien for the unsecured creditors and does not allow junior lienholders to move up in this situation because the reduction of the IRS lien payment results from bankruptcy and not from any infirmity in the IRS lien itself.  I will not go through the whole BC 551 analysis here as it plays an important role for the unsecured creditors and for the decision of the court not to abandon the property but does not impact the outcome between the IRS and the trustee.  I agree with the court’s analysis of the way section 551 works generally and works specifically in this case.

Because of the absence of case law governing this situation, it will be interesting to see whether the government appeals.  The trial section clearly disagrees with the outcome as evidenced by its appeal of the bankruptcy court decision.  The case could result in an interesting discussion in the room of lies.

Taxpayer Fends Off Nominee Lien Challenge at Summary Judgment Stage

Court decisions on nominee liens occur infrequently and taxpayer victories in such cases occur quite rarely.  So, the decision in Dombrowski v. United States, No. 3:18-cv-11615 (E.D. Mich. 2020) provides a glimpse at what it takes to remove a nominee lien from a third party’s property.  We have previously discussed nominee liens here and here.  The procedural posture of this case has the court ruling on cross motions for summary judgment.  Because the court does not resolve the case on these motions, a second post on this case remains a possibility if the case goes to trial.  The rarity of this type of case makes discussion of the outcome of the summary judgment motions worthwhile.

As is true in any nominee case, the person seeking to remove the nominee lien intertwined her life and her finances with someone owing substantial tax liabilities. As you read the facts in this case you might ask yourself why someone would entangle their finances with someone who has this many problems with the IRS (and usually others), but the test for whether a nominee holding exist do not test for rational financial decisions but for real, as opposed to fake or apparent, financial actions. Here, the plaintiff convinces the court of the possibility of real financial consequences she has suffered.

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Ms. Dombrowski has lived with Mr. Matheson since 2006 though they have never married.  She lent him $171,000 in 2006 with funds pulled from her retirement account.  He promised to pay her back within months and gave a promissory note for 100% interest.  At approximately the same time her brother loaned Mr. Matheson almost the same amount on the same terms.  Later that year she loaned Mr. Matheson another $50,000.  The opinion does not say why she would do this.

The following year Mr. Matheson gave checks to Ms. Dombrowski and her brother to pay off the loan to each but asked them not to cash the checks.  They continued to loan Mr. Matheson money.  Meanwhile, Mr. Matheson ran up a tax debt to the IRS which now stands at over $3 million.

In 2013 Mr. Matheson defaulted on the mortgage on the property where he resided with Ms. Dombrowski.  On June 25, 2013, Mr. Matheson transferred $220,000 to Ms. Dombrowski and $80,000 to her brother.  She and her brother claim these payments were partial repayment of the previously loaned money.  The brother gave the money he received to Ms. Dombrowski on June 27, 2013.  On July 10, 2013 she purchased a house for $229,900 and the house was deeded in her name.  Mr. Matheson has essentially lived with her since the house was purchased.  In 2017 the IRS filed a nominee lien on the house taking the position that Ms. Dombrowski held the house as the nominee of Mr. Matheson.

Unlike the federal tax lien which the IRS files in the name of the taxpayer and not against specific property, a nominee lien names the taxpayer, the nominee and the specific property subject to the nominee lien.  Also unlike the federal tax lien which many collection employees may file without supervisor or Chief Counsel approval, the filing of a nominee lien requires specific approval from Chief Counsel’s Office.  Without knowing more than the brief facts recounted by the court and detailed above, it is easy to understand why the attorney reviewing this case would approve the nominee lien, though the existence of a valid loan could provide the basis for the transfer from the taxpayer to Ms. Dombroski.  The goal of the nominee lien is to preserve lien priority and not to resolve title.  Additionally, unlike the filing of the notice of federal tax lien, the filing of a nominee lien does not, according to the IRS, provide the nominee with the opportunity for a Collection Due Process hearing.  Guest blogger Lavar Taylor discussed this issue in a five part series.  Ms. Dombrowski brought this suit to quiet title and remove the nominee lien.

The IRS argued that Mr. Matheson’s transfer of $300,000 to Ms. Dombrowski and her brother in 2013 at a time when he owed the IRS over ten times that amount provided three bases for the IRS to pursue the property in order to collect on the outstanding liability owed to it.  First, the IRS argues that the transfer violates Michigan’s Uniform Voidable Transfers Act.  Second, it argues that the court could impose a resulting trust, and third it argues that the lien is proper because she held the property as a nominee for Mr. Matheson.

To prove a violation of the Michigan voidable transfers law the IRS must prove four elements: 1) transfer to an insider; 2) transfer made to pay an antecedent debt; 3) that Matheson was insolvent at the time of transfer; and 4) the recipient had reasonable cause to believe Matheson was insolvent.  Ms. Dombrowski first argued that the IRS action was time barred, but the court turned away this argument finding that even though the IRS was relying on a state cause of action, the federal statute of limitations applies.  She admitted three of the four elements of the statute but contested that she was an insider.  In declining to grant summary judgment to the IRS, the court determines that a jury must decide the question of fact regarding her insider status.  So, the IRS loses its effort to end the case on this basis.

Next, the court turns to the argument that the property is subject to a resulting trust.

A trust arises in favor of a debtor’s creditors when the debtor pays for property subsequently titled under a third-party’s name. Id.; see Advance Dry Wall Co., 218 N.W.2d at 868 (“[The] statute would create an equitable interest in [purchased] land in favor of [a] . . . creditor since the valuable consideration for the land was paid for by [the debtor] but the title was taken exclusively in the names of [third-parties].”). Such a transaction creates a presumption of fraudulent intent, and it is the third-party’s responsibility to produce evidence to rebut it. Mich. Comp. Laws § 555.8

Ms. Dombrowski logically argues that she bought the property with funds paid to her in repayment of prior loans and not with money owned by Mr. Matheson.  The court walks through the arguments available to each side on this issue before deciding that a jury must resolve this issue given the competing facts.

Lastly, the court addresses the nominee theory.  Given its decision regarding the first two theories, one might be tempted to predict where this issue will end, but the case takes a twist based on the legal theory upon which the IRS relied for proving the nominee theory.

Drawing on federal revenue caselaw that “the [IRS] may collect the tax debts of a taxpayer from the assets of his nominee, instrumentality, or alter ego,” the court in Porta-John analyzed the corporate relationships under a theory of nominee liability. Id. at 700 (citing G.M. Leasing Corp. v. United States, 429 U.S. 338, 350-51 (1977); Lemaster v. United States, 891 F.2d 115 (6th Cir. 1989)). The court relied on no Michigan law for its determination. Id. at 701. It relied upon opinions from the Northern District of New York, the District of Montana, and the Second Circuit, to set the following standard for nominee liability:

In order to establish that property is held by a nominee, the [c]ourt must consider six factors: (1) whether inadequate or no consideration was paid by the nominee; (2) whether the property was placed in the nominee’s name in anticipation of a lawsuit or other liability while the transferor remains in control of the property; (3) whether there is a close relationship between the nominee and the transferor; (4) whether they failed to record the conveyance; (5) whether the transferor retains possession; and (6) whether the transferor continues to enjoy the benefits of the transferred property.

It’s not often a leading case in a tax issue is named Porta-John. The court declined to follow the reasoning in the Porta-John case, because no Michigan case had cited to it and the 6th Circuit had not determined it applied.  Because state law controls the property interest and because the state law had not yet adopted the theory set out in the Porta-John case, the court here would not apply the law of that case to find a nominee situation. 

The Sixth Circuit mentioned that some courts have applied the Porta-John factors when evaluating questions of alter-ego liability. Id. at 253 n.2. Nonetheless, the Spotts court noted that “federal courts have looked to the decisions of other courts for guidance” only when “a forum state does not have clear law on the issue.” Id. at 253. The court held that a state did have “clear law” where it allowed the IRS to enforce its rights to tax debts through a constructive trust on third-party property. Id. Further, the court cautioned, even in cases where law outside the forum state can be used, “rigid adherence to [the Porta-John] factors may not be appropriate for every case.” Id. at 253 n.2. The unique facts of a case may not fit well within Porta-John’s factors, such as when the alleged nominee is a spouse, and courts may disregard Porta-John as needed. Id….

Michigan has “clear law” on alter-ego liability. Spotts, 429 F.3d at 253. Because Porta-John’s nominee theory is not derived from Michigan state law, summary judgment in favor of Plaintiff will be granted. Nat. Bank of Comm., 472 U.S. at 722; Fed. R. Civ. P. 56(a). There are no factual issues, and as a matter of law, Defendant’s Porta-John argument fails. Fed. R. Civ. P. 56(a).

So, the case moves forward on the first two theories, but the government’s Porta-John theory will have to wait for another day.  The IRS can raise this theory again on appeal if it loses the other issues.  It’s hard to say who will win because the case turns on facts not yet fully developed.  Ms. Dombrowski is a loser in some respects because she must expend time and effort to defend the property from taking.  Even if she ultimately wins, it will be a costly victory for her.  Similarly, for the IRS, clearing title to get to this property which will only satisfy a small portion of the overall liability is proving costly.  This is what happens when a title is clouded.

Proving a Federal Tax Lien Has Expired

In the 1980s the IRS adopted self-releasing notices of federal tax lien (FTL).  The self- releasing lien saves the IRS time and effort of going to all of the courthouses where it files liens and recording a release.  One of the problems taxpayers have with the self-releasing lien comes from the lack of a specific piece of paper, the release, demonstrably showing the end of the lien.  Other problems can result from the self-releasing lien such as the failure of the IRS to refile all of the lien notices it has on file allowing one or more of several lien notices to self-release while refiling others.  This post will not address that problem though it does pose one of the difficulties with the self-releasing system.

The IRS filed a notice of federal tax lien (NFTL) against Todd Gordon in Clearfield County, Pennsylvania in 2005.  In the recent case of Gordon v. United States, No. 3:19-cv-00187 (W.D. Pa. 2020) the court examines the situation of the self-releasing lien and resolves some confusion in the state court regarding the NFTL.

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Not to belabor the background of FTLs but to quickly cover the basics for anyone not familiar with such liens, the FTL arises with the occurrence of three things: (1) assessment of the federal tax liability; (2) proper issuance of notice and demand pursuant to IRC 6303 (mailing the taxpayer a demand letter); and (3) neglect or refusal to pay the tax.  Take note that the existence of the FTL has nothing to do with recordation of the lien.

Because only the IRS and the taxpayer know about the FTL, Congress designed protections for competing creditors to allow the smooth flow of commerce.  The 1966 Federal Tax Lien Act established the system for the filing of the NFTL and the resolution of competition between the FTL and other creditors or persons with interest, such as purchasers, in property encumbered by a FTL.  IRC 6323 requires the IRS to record the FTL by way of a NFTL in order to perfect the FTL against certain parties.  The Gordon case concerns a filed NFTL and its self-releasing feature.

Although the court does not specifically talk about Mr. Gordon’s federal tax issues, I assume that he owed some amount of federal taxes which went unpaid after assessment.  The IRS then decides whether it wants to perfect its tax lien by filing an NFTL.  That decision embodies some policy concerns regarding the amount of the liability and the likelihood of the NFTL providing a benefit to the IRS in collecting the taxes.  I discuss these issues in a paper here.

In Mr. Gordon’s case, the IRS decided to file the NFTL and appears to have recorded it in the county where he lived.  That location follows the requirement in IRC 6323 that the IRS record the NFTL in the county where the taxpayer resides in order to perfect the FTL with respect to all of the taxpayer’s personal property.  It also usually results in perfecting the FTL with respect to the taxpayer’s home since the home is located where the taxpayer lives.  The NFTL perfects the FTL with respect to any real property the taxpayer owns in the county where the IRS records it.  If the taxpayer owns real property in jurisdictions outside the county of residence, the IRS must file a NFTL in each of those counties in order to perfect the FTL with respect to the real property in those other locations.

The statute of limitations on collection limits both FTL and the NFTL.  The statute of limitations on collection lasts for ten years unless something suspends it, e.g., an offer in compromise, a Collection Due Process request, living outside the US continuously for more than six months and several other actions.  Here, the IRS filed the NFTL on September 6, 2005.  Because it normally takes several months after the assessment before the IRS files the NFTL, the statute of limitations on assessment would run from the date of the earlier assessment and not from the date of the recording of the NFTL.  Although it filed the NFTL against Mr. Gordon, the IRS did not bring suit against him nor did anything else suspend the statute of limitations on assessment.  The ten years from assessment ran at some point before September 6, 2015.  The NFTL self-released.  Release is a term of art here defined in IRC 6325(a) and it means, inter alia, that the lien is unenforceable.

Probably because the self-releasing feature of the lien does not provide a sufficiently affirmative statement of the death of the NFTL, Mr. Gordon brought an action in 2019 in the state court in the county where the IRS filed the NFTL to strike the lien.  The IRS, as it almost always does when sued in state court, removed the case to the federal district court.  The IRS does not like to engage in litigation in state courts.  After removal, the IRS moved to dismiss the case for lack of subject matter jurisdiction and failure to state a claim.  After all, the NFTL itself provided for exactly the relief Mr. Gordon sought in suing the IRS.  The IRS, no doubt, felt that defending the suit wasted its time and defeated the purpose of the time saving self-releasing feature of the NFTL.

The court states that “Gordon’s petition seeks to strike the NFTL, but all parties agree that the NFTL is no longer active, and therefore there is no active controversy over which this Court has jurisdiction.”  Mr. Gordon, however, argues that because of a judgment entered by the state court on its docket an active controversy exists.  The court disagrees with Mr. Gordon and states “this case is moot because there are no longer live issues before this Court and it is unable to effectively render relief.  The USA has also granted Gordon the relief he seeks to the extent that it can.”

The only dispute remaining is not a dispute with the IRS but with the state court which filed a judgment in error.  So, the court remands the case to the state court but with the IRS out of the picture.  I hope that Mr. Gordon can get the state court to remove the judgment.  The issue of seeking a clearer statement of release arises occasionally and taxpayers seek from the IRS some affirmative statement that the lien no longer exists rather than trying to rely on the negative implication of the self-releasing lien.  The IRS has a procedure for taxpayers to use in order to obtain a statement of the release that they could show to prospective creditors in order to clear up any uncertainty.  The provisions exists in IRM 5.12.3. I do not know if these provisions would assist Mr. Gordon in resolving his problem with the lien, but there may be others who want something more than a self-released lien to prove that the NFTL no longer actively reflects a liability owed to the IRS.

Taxpayer Wins Rare Reversal in CDP Lien Appeal

Last week we covered Collection Due Process in the Federal Tax Clinic seminar at Villanova. Each student had to find a CDP opinion authored by a judge coming to Philadelphia this spring, and present the opinion to the class. I like this exercise, but it is somewhat discouraging. In all the cases presented this semester (and most semesters), the taxpayers were self-represented, and they all lost their appeals. As one student after another explains why the IRS did not abuse its discretion in their case, the exercise shows the wide discretion that the IRS enjoys in the collection domain, and the Tax Court’s deferential standard of review.

Collection Due Process is not always a futile exercise, however. Carl Smith alerted the PT team to an interesting bench opinion posted in December 2019, Cue v. Comm’r, where the Tax Court flatly rejected the IRS’s lien determination. The Cue opinion is unusual not just because the Court found abuse of discretion on a lien determination, but also because the Court did not remand the case to Appeals.

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The Secret Lien, the NFTL, and Collection Due Process

Before we get to the Cue case, a brief reminder of the lay of the land. The Notice of Federal Tax Lien is a powerful compliance tool. While a “secret lien” in favor of the government arises by operation of law, the Notice of Federal Tax Lien (NFTL) perfects this lien and alerts the world (and the taxpayer’s other creditors) to the government’s claim on the taxpayer’s property. The unperfected “secret” lien can be defeated by creditors who would have to fall in line behind a perfected lien.

So when a taxpayer fails to pay the government, it makes sense that the government would protect its priority against other creditors by filing an NFTL. However, this can cause a hardship for taxpayers, as prospective landlords, lenders, suppliers, and customers may see the lien and decline to do business with the taxpayer. Taxpayers without stable housing are particularly vulnerable. The NFTL also seems excessively punitive where the taxpayer has no significant assets and no realistic chance of acquiring any. NFTLs are filed against taxpayers, not against particular pieces of property, and there is no requirement that a taxpayer own real estate or significant assets before the government can perfect its lien. Keith wrote about the problems caused by systematic lien filings in low-dollar cases here. Since Keith’s article was published, the IRS Fresh Start Initiative raised the filing threshold from $5,000 to $10,000. Still, NFTL filing remains a concern for low-income taxpayers, and it is still a tool wielded systemically by the IRS’s automated collection system.

Collection Due Process acts as a check on the juggernaut of automated collections by requiring Appeals to engage in a balancing test, finding that the IRS’s proposed collection action “balances the need for efficient collection of taxes with the legitimate concern of the person that any collection action be no more intrusive than necessary.” IRC 6330(c)(2)(A).

One might think, at least for taxpayers who own little to no property, that the balancing test would favor restraint. But where IRS policy requires a lien determination, the taxpayer faces an uphill battle to prove that the NFTL will cause a specific serious hardship or impair their ability to pay the tax debt. And the Tax Court reviews the IRS’s determination for abuse of discretion. This leads to cases like Richards v. Commissioner, T.C. Memo. 2019-89, in which Judge Vasquez held that it was not abuse of discretion for Appeals to sustain an NFTL filing against taxpayers in Currently Not Collectible status whose only income was from Social Security.

Mr. Richards pointed out that the NFTL was doing the government no good, whereas on his side of the balancing test it hurt his credit rating and he feared it would hurt his chances of getting a car loan. Unfortunately, the Court found this “bare assertion is insufficient to establish that lien withdrawal would facilitate collection or would be in the United States’ best interests.” Regarding the balancing test, the Court noted,

petitioners do not contend that [Settlement Officer] Piro misinterpreted the IRM in making her determination. Nor did petitioners present any concrete evidence during the CDP hearing to demonstrate how the NFTL would negatively affect their financial circumstances and credit standing.

…SO Piro actually considered Mr. Richards’ argument about petitioners’ credit standing and pursued a followup inquiry. Specifically, SO Piro asked whether the NFTL would affect petitioners’ ability to earn income. After learning from Mr. Richards that their only income source was Social Security, SO Piro determined that the NFTL was not overly intrusive and was necessary to protect the Government’s interest. This determination was well within her discretion.

So the first hurdle a taxpayer faces in fighting a NFTL determination is proving that there is a specific harm caused by the public lien filing, and this should be a harm which impedes collectability of the tax debt. Carl Smith gave a good example in an email:

At Cardozo, I once got a lien withdrawn at a CDP hearing for a person who had virtually no money, but had been working on a screenplay with a big Hollywood producer. I got a letter from the producer saying that he could not have my taxpayer listed among the creative team (or paid) if he was going to seek financing for the film, since investors do tax lien searches on creative teams before investing money. In order to help her possibly earn money from her screenplay work, the SO agreed to remove the filed lien (she had no other property the lien would secure) and leave her in CNC. But, I almost never hear of anyone else successfully getting a lien withdrawn.

Eberto Cue v. Commissioner

Finally we get to today’s case and taxpayer Eberto Cue. Carl Smith described the case:

There was a pro se CDP case on Judge Goeke’s Nov. 12 calendar involving a banker who owed money for taxes reported on two older returns.  The debt had gone into CNC.  Then, the IRS filed a tax lien.  (He owns a condo.)  It appears he had recently gotten a job as a banker that, like many in the financial industry, prohibits his having a notice of federal tax lien filed against him.  In his Form 12153, he asked for the lien filing to be withdrawn, explaining that he would lose his license and his job if the lien notice were not withdrawn. 

Mr. Cue did not propose any collection alternatives. The Appeals settlement officer (SO) offered him three options under which she would withdraw the NFTL:

  1. a direct debit installment agreement under which the total liability would be paid off within 60 months;
  2. immediate full payment; or
  3. documentation that Mr. Cue would lose his job if the notice was not withdrawn.

Not surprisingly, Mr. Cue chose Option 3. On 8/14/18 Mr. Cue sent the SO a letter with information about his banking license. This showed that federal tax liens “would be noted by the licensing officials adversely to his request to renew his license, which he had to renew every year…”

The SO then essentially reneged on her offer. She found that Mr. Cue “was already in breach of the licensing requirements, apart from the Notice of Federal Tax Lien filing,” because he “owed the federal government, and [his] home was foreclosed.” Therefore, she disregarded his documentation and his argument. In a Notice of Determination dated 9/26/18, the SO determined that the account would remain in CNC status, but the lien filing was sustained. Mr. Cue filed a timely petition to the Tax Court.

The Court’s opinion notes that during the CDP appeal, Mr. Cue discussed the NFTL with his employer as required by his banking license. On 8/19/18 he was advised, “You are ineligible to remain in your current position due to your outstanding tax lien.” It is unclear from the opinion whether the SO had this evidence to consider before the Notice of Determination.

Carl Smith:

…the SO did not withdraw the lien notice, and the taxpayer thereafter lost both the job he had at the bank requiring the license and any other job at the bank.  He has been unemployed ever since, relying on being supported by his wife.  So, ultimately, the IRS got nothing by its collection efforts (except possibly priority if the condo gets sold, assuming there is any equity in it).

The IRS had moved for summary judgment exactly 60 days before the calendar call.  Judge Goeke set the motion to be argued at the calendar call. 

At the calendar call on November 12, Attorney Karen Lapekas entered a limited entry of appearance for Mr. Cue. Judge Goeke denied the IRS’s motion for summary judgment and held the trial that same day.

If one goal of CDP is to find an appropriate collection alternative benefiting both the taxpayer and the Treasury, it seems odd that neither petitioner nor the SO in this case proposed an affordable monthly payment as a way to avoid a NFTL. To Judge Goeke, the SO’s reasoning (Mr. Cue was already exposed to losing his license, so the NFTL would not matter) “overlooked the fact that the petitioner had been employed for some time, and was in a position to generate income…”

…it was unreasonable for the settlement officer to overlook the impact of the lien and its public filing on the petitioner’s employment. Her failure to seriously consider the petitioner’s assertions that he would lose his position demonstrates that the settlement officer did not seriously intend to act on the third condition that she provided the petitioner in the telephonic hearing. …the fact that the settlement officer did not seek a reasonable payment from the petition[er] demonstrates that the settlement officer was not actually interested in generating collection from the petitioner, but merely wished to sustain the Notice of Federal Tax Lien.

The Court went on to hold

Given these circumstances, we believe the settlement officer’s actions were arbitrary and capricious, and we sustain the petitioner’s argument that the Notice of Federal Tax Lien should be withdrawn. … We do not look at his current situation [and re-weigh the balancing test]. Rather, we look at the actual analysis of the settlement officer, contemporaneous with the determination, … [and] that analysis we find to be arbitrary and capricious.

Reverse or Remand?

Generally, where abuse of discretion is found the Court will remand the case to Appeals for a supplemental hearing. The lien determination cases of Budish v. Comm’r and Loveland v. Comm’r (blogged by Keith here) and the levy case Dang v. Commissioner (blogged by Keith here) are all good examples of this practice. Keith wrote about the frustration that can result from repeated remands in CDP cases here.

In Mr. Cue’s case however, Judge Goeke simply reversed the Settlement Officer and declined to sustain the Notice of Determination. Under the circumstances, this seems appropriate. The NFTL clearly had cost Mr. Cue his ability to work in banking and had destroyed his ability to make payments towards his tax debts. Under these facts, no reasonable settlement officer could sustain the notice of federal tax lien.

 

Lien Priority Litigation

The case of Shirehampton Drive Trust v. JP Morgan Chase Bank et al.; No. 2:16-cv-02276 (D. Nev. 2019) presents a relatively straightforward lien priority fight.  The case shows the continued fallout from the great recession.  It also shows the perils of purchasing property at a foreclosure sale.  When a federal tax lien exists, such a purchase becomes especially perilous, as the purchaser discovers here.  I remember as a district counsel attorney having to deal with a few unsophisticated purchasers at foreclosure sales who discovered to their sorrow that the property which they thought they had purchased at such a bargain, would cost them much more than anticipated because of a federal tax lien that the sale did not defeat.  The Shirehampton case does not break new ground but merely serves as a cautionary tale.

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In 2008 Louisa Oakenell purchased property located at 705 Shirehampton Drive, Las Vegas, Nevada 89178 (“the property”). The property sits in a community governed by the Essex at Huntington Homeowners Association (“HOA”). The HOA requires its community members to pay dues.  At the time she purchased the property, she already owed the IRS significant income tax liabilities for 2005 and 2006.  The court described the relevant facts as follows:

This matter concerns a nonjudicial foreclosure on a property located at 705 Shirehampton Drive, Las Vegas, Nevada 89178 (“the property”). The property sits in a community governed by the Essex at Huntington Homeowners Association (“HOA”). The HOA requires its community members to pay dues.
 
Louisa Oakenell borrowed funds from MetLife Home Loans, a Division of MetLife Bank, N.A. (“MetLife”) to purchase the property in 2008. To obtain the loan, Oakenell executed a promissory note and a corresponding deed of trust to secure repayment of the note. The deed of trust, which lists Oakenell as the borrower, MetLife as the lender and Mortgage Electronic Registration Systems, Inc., (“MERS”) as the beneficiary, was recorded on December 24, 2008. MERS assigned the deed of trust to Chase in May 2013.
 
Oakenell fell behind on HOA payments. The HOA, through its agent Red Rock Financial Services, LLC (“Red Rock”) sent Oakenell a demand letter by certified mail for the collection of unpaid assessments on June 26, 2009. On July 21, 2009, the HOA, through its agent, recorded a notice of delinquent assessment lien. The HOA sent Oakenell a copy of the notice of delinquent assessment lien on July 24, 2009. The HOA subsequently recorded a notice of default and election to sell on October 21, 2009 and then a notice of foreclosure sale on September 18, 2012. Red Rock mailed copies of the notice of default and election to sell to Oakenell, the HOA, Republic Services, the IRS, and Metlife Home Loans. Red Rock did not mail a copy of the notice of default and election to sell to MERS. On January 28, 2013, the HOA held a foreclosure sale on the property under NRS Chapter 116. Shirehampton purchased the property at the foreclosure sale. A foreclosure deed in favor of Shirehampton was recorded on February 7, 2013.

In addition to falling behind on her HOA payments, however, Oakenell also stopped paying federal income taxes. The IRS subsequently filed notices of federal tax liens against Oakenell at the Clark County Recorder’s office on May 1, 2009 and June 24, 2009. As of October 1, 2018, Oakenell had accrued $250,953. 37 in income tax liability plus daily compounding interest.

For any reader not familiar with the federal tax lien, a quick detour into lien law may help.  For a more detailed discussion of this lien law, refer to Saltzman and Book, “IRS Practice and Procedure” at chapter 14.04, et seq.  When the IRS makes an assessment, it sends a notice and demand letter (required by IRC 6303) almost immediately thereafter.  If the taxpayer fails to pay the tax within the time prescribed in the notice and demand letter, the federal tax lien comes into existence relates back to the date of assessment and attaches to all of the taxpayer’s property and right to property.  The lien also attaches to all after-acquired property as long as the lien remains in existence.  In this case the federal tax lien would have attached to the property Ms. Oakenell purchased immediately upon closing; however, at that time the lien was known only to the IRS and Ms. Oakenell, since the IRS had not yet made the lien public by filing a notice of the lien.

In 1966 Congress passed the legislation establishing the lien priority rules that still apply today.  Congress gave the federal tax lien the broadest possible power; however, it limited that power by creating a first in time rule in IRC 6323(a).  That first in time rule allows a competing interest to defeat the federal tax lien if perfected prior to perfection of the federal tax lien.  Perfection of the federal tax lien occurs when the IRS files the notice in the appropriate place.  In this case the fight concerns the timing of the filing of the lien and not the location.

Because the notice of federal tax lien was filed here prior to the filing of the lien for the HOA, the federal tax lien defeats the lien of the association.  HOA fees seem a lot like local real estate taxes; however, if competing with the federal tax lien, the two types of ownership liens operate differently.  The real estate taxes, even though they arise after the existence of the filing of federal tax lien, come ahead of the filed federal tax lien because of IRC 6323(b)(6)(a).  Congress added this subparagraph in 1966 to avoid circular priority problems which arose when a real estate taxes went unpaid after the filing of a notice of federal tax lien.  Prior to 1966 courts had to struggle with the situation, because the purchase money mortgage defeated the IRS lien, the IRS lien defeated the later arising real estate taxes and the real estate taxes defeated the purchase money mortgage.  With the passage of this provision, Congress had the IRS step back in order to allow the real estate taxes to come before the IRS; however, it did not do the same for HOA fees.  As a consequence, the IRS defeats HOA fees that get recorded after the notice of federal tax lien.  Since that happened here, the purchaser bought the property subject to the substantial tax liabilities secured by the federal tax lien.  A very unfortunate result for the purchaser and one that should never occur but which does with surprising frequency.

In addition to the Shirehampton case, another lien priority case was recently decided, United States v. Patrice L. Harold et al.; No. 2:18-cv-10223.  I will discuss the Harold case in an upcoming post.

Will the IRS Take My Home?

LITC practitioners hear recurring worries from taxpayers with IRS problems: will I go to jail? will the IRS take my home? For the vast majority of people who owe taxes, the answer to both questions is no. Someone who simply owes a tax debt usually does not need to worry about going to jail or having their home taken by the IRS. However, this is not to say it never happens. There are perhaps one or two cases per month reported on daily tax news services, and the National Taxpayer Advocate’s 2017 Annual Report to Congress identified 60 opinions in that fiscal year involving section 7403Recent cases illustrate the steps the government must take and the factors courts consider when evaluating a request to foreclose. 

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The government has two separate legal mechanisms to seize a taxpayer’s home in order to collect a tax debt. The National Taxpayer Advocate explains in her 2017 ARC Purple Book: 

The IRS has two options, which cannot be used concurrently, to collect against the principal residence of a taxpayer or a residence that is owned by the taxpayer but occupied by the taxpayer’s spouse, former spouse, or minor child. One option is to obtain a court order allowing administrative seizure of a principal residence under IRC § 6334(e)(1). … The other option is a suit to foreclose the federal tax lien against a principal residence under IRC § 7403.

The IRS makes use of both options, by way of making a recommendation and referral to the Department of Justice Tax Division, which represents the IRS in Federal District Court. The IRM explains that  

[s]uits should still be brought to foreclose the federal tax lien and reduce the tax liability to judgment in lieu of bringing a section 6334(e)(1) proceeding whenever it is determined that such suits would be optimal. A lien foreclosure suit may be preferable to a section 6334(e)(1) proceeding when there are questions regarding title or lien priority that create an unfavorable market for administrative sale. See 35.6.3.2 for discussion of lien foreclosure suits. A lien foreclosure suit may also be a specific option when the collection statute of limitations is about to run.  

34.6.2.5.1 (06-12-2012), Procedures for Instituting a 6334(e)(1) Proceeding.  So, taxpayer representatives should be familiar with the requirements for both actions.

Administrative seizure with judicial approval 

In August of 2018, Keith blogged about an Eighth Circuit decision under section 6334United States v. Brabant-Scribner, No. 17-2825 (8th Cir. Aug. 17, 2018). Keith explains: 

The 1998 Restructuring and Reform Act added IRC 6334(e)(1)(A) to require that prior to seizing a taxpayer’s principal residence the IRS must obtain the approval of a federal district court judge or magistrate in writing. Before the passage of this provision, the IRS could seize a taxpayer’s home with the same amount of prior approval needed to seize any other asset owned by the taxpayer. No approval was necessary to seize any asset of the taxpayer.

The government has adopted Treasury Regulation 301.6334-1(d) incorporating additional procedures and standards. Keith summarizes: 

To convince the court to allow the sale of a personal residence, the IRS must show compliance with all legal and procedural requirements, show the debt remains unpaid and show that “no reasonable alternative” for collection of the debt exists. 

… the taxpayer has a right to object after the IRS makes its initial showing and “will be granted a hearing to rebut the Government’s prima facie case if the taxpayer … rais[es] a genuine issue of material fact demonstrating … other assets from which the liability can be satisfied.”  

Also, the regulation provides for written notice to family members and occupants of the property.  

Unfortunately for taxpayers, judicial approval may not be difficult for the IRS to obtain despite the above standards and procedures. In Brabant-Scribner, the court reasoned that an alternative “for collection” must provide for payment of the debt; therefore, it held that the IRS was not required to consider the taxpayer’s offer in compromise. Similar reasoning has been followed by other courts. E.g. United States v. Gower, No. 3:16-cv-01247 (M.D. FlaJul. 10, 2018). Nevertheless, the administrative collection statutes and regulations provide some procedural protections for the taxpayer and certain family members living in a home owned by the taxpayer. IRM procedures also provide significant safeguards, which the National Taxpayer Advocate has recommended that Congress codify in section 7403

Suit to foreclose judgment lien 

The government’s second option, if it seeks to seize a taxpayer’s home, is to foreclose the federal tax lien by filing suit pursuant to section 7403Les has discussed section 7403 previously, and I will borrow his summary:

Under Section 7403, a federal district court can “determine the merits of all claims to and liens upon the property, and, in all cases where a claim or interest of the United States therein is established, may decree a sale of such property,…, and a distribution of the proceeds of such sale according to the findings of the court. 

Yet that power to force a sale and distribution of the proceeds is limited. In the 1983 case US v Rodgers the Supreme Court said that while the government has broad discretion to force a sale, “Section 7403 does not require a district court to authorize a forced sale under absolutely all circumstances, and that some limited room is left in the statute for the exercise of reasoned discretion.” Keith has discussed the application of Rodgers in prior posts here and here. 

To assist courts in exercising that discretion, Rodgers identifies factors: 

1) “the extent to which the Government’s financial interests would be prejudiced if it were relegated to a forced sale of the partial interest actually liable for the delinquent taxes[;]” 

(2) “whether the third party with a nonliable separate interest in the property would, in the normal course of events (leaving aside § 7403 and eminent domain proceedings, of course), have a legally recognized expectation that that separate property would not be subject to forced sale by the delinquent taxpayer or his or her creditors[;]” 

(3) “the likely prejudice to the third party, both in personal dislocation costs and … practical undercompensation [;]” and 

(4) “the relative character and value of the nonliable and liable interests held in the property ….”

Once the government has decided to sue for foreclosure, the taxpayer and others hoping to prevent that outcome face an uphill battle. The government prevailed in 58 of the 60 cases identified by TAS in the 2017 Annual Report to Congress, and one case resulted in a split decision. The taxpayer prevailed in only one case. These lopsided statistics are consistent with prior years’ reports.  

At times courts’ analysis of the Rodgers factors is cursory or nonexistent, but sometimes the factors do make a difference and judicial discretion is exercised. In United States v. Kwitney, No. 6:18-cv-1366-Orl-37TBS (M.D. Fla. Feb. 8, 2019), the district court rejected a magistrate’s recommendation in favor of foreclosure, because the interests of a third party had not yet been adjudicated.  

A less happy outcome for the interested third party occurred on January 30 in United States v. Jackson, No. 3:16-cv-05096 (W.D. Mo. Jan. 30, 2019). Mr. Jackson’s wife jointly owned properties with him, but she was not liable for the tax debt. Unfortunately for her, Mrs. Jackson came to the court with unclean hands, having previously collaborated with Mr. Jackson in what the court found were fraudulent transfers of the property. The court nevertheless examined the Rodgers factors: 

With respect to the first factor, the Court finds Plaintiff’s financial interests would be prejudiced if it were relegated to the forced sale of only Phil Jackson’s interest in the Properties. As a practical matter, if Plaintiff foreclosed on Phil Jackson’s interests only, Sharon Jackson retains her interests in the Properties. Thus, the sale of Phil Jackson’s interests would not decrease the judgment amount Phil Jackson owes to Plaintiff. 

Translation: it will be hard, perhaps impossible, to find a buyer for Mr. Jackson’s half-interest in the property. The government is likely to collect nothing under this alternative.  

With respect to the second factor, Sharon Jackson lacks an expectation that the Properties would not be subject to sale. Sharon Jackson, as owner with Phil Jackson, participated in the fraudulent transfers (since disclaimed) of the Properties. In the Court’s view, this conduct “tilts the balance of legal expectation against” her under this factor. United States v. Bierbrauer, 936 F.2d 373, 376 (8th Cir. 1991). 

With respect to the third factor, Sharon Jackson will receive full compensation for her interests in the Properties. … 

Finally, with respect to the fourth factor, because Phil Jackson’s and Sharon Jackson’s interests in the Properties are equal, forced sale could net Plaintiff as much as half the value of each of the properties to apply to the tax judgment against Phil Jackson. Under these circumstances, the Plaintiff is likely to recover more than “a fraction of the value of the property.” Bierbrauer, 936 F.2d at 375. 

Mrs. Jackson also argued that if the properties were sold, she should receive half of the sale price before any of the sale expenses were deducted and before certain property tax liens were paid. The Court held against her on both counts. As co-owner Mrs. Jackson was equally liable for the property taxes, and the court reasoned that her legal interest in the property is subject to those liens. Regarding the administrative costs of sale,  

[The Jacksons] cite no legal authority for the premise that the sale costs for the Properties should be borne by Plaintiff. Thus, the Court relies on “the Government’s paramount interest in prompt and certain collection of delinquent taxes” to conclude that Plaintiff net proceeds from the sale of the Properties should be distributed to PALS first. Rodgers, 461 U.S. at 712. 

The government’s “paramount interest” certainly makes these cases very difficult for taxpayers and their family members to win.

The bottom line 

The case numbers are low: the government probably won’t try to seize your home for back taxes. However, it’s in taxpayers’ interests to resolve their collection disputes rather than ignore the IRS. And certainly, don’t try any funny business with fraudulent transfers.

Ponzi Scheme Victims Seek to Defeat the Federal Tax Lien with Constructive Trust Argument

All too often a person cheating others ends up pitting the defrauded individuals against the IRS in a battle over the remaining assets of the cheater. The most recent version of this longstanding problem exists now in the Ninth Circuit case of Wadsworth v. Talmage, 123 AFTR 2d 2019-305 (911 F.3d 994), (9th Cir. 2018) (order certifying question to the Supreme Court of Oregon). On December 27, 2018, the Ninth Circuit declined to sustain the dismissal of the action by the district court and certified the issue of the meaning of a constructive trust in Oregon to the Oregon Supreme Court. Presumably, the Oregon Supreme Court’s decision on the application of constructive trusts in that state will allow the Ninth Circuit to reach a decision on whether property existed to which the federal tax lien could attach.

These types of cases put the IRS in the awkward position of taking the assets of the thief to satisfy outstanding tax debts resulting from the theft. By taking those assets, the IRS prevents the actual victims of the theft from receiving restitution. I am always pulling for the victims in these cases because it does not seem right to me that the tax authority should take the money instead of the actual victims of the theft. I have written about these types of situations previously in the bankruptcy context, here and here, in circumstances in which the issue was whether the court could order a clawback of the money from the IRS.

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The Ninth Circuit describes the basic facts regarding the use of the money fraudulently obtained from investors:

John Wadsworth and other members of the RBT Victim Recovery Trust (collectively, “the Trust”) allege that Ronald Talmage, an investment manager, began fraudulently diverting his clients’ funds in the 1990s as part of a Ponzi scheme. Members of the Trust entrusted Talmage with “over $55 million” between 2002 and 2015.

In 1997, Talmage and his first wife purchased RiverCliff for almost $1 million. The property was purchased with the proceeds of Talmage’s Ponzi scheme. From 1998 to 2008, Talmage spent over $12.5 million of entirely stolen funds to improve the property. Talmage paid his first wife $1.5 million dollars in 2005 using money “stolen . . . from . . . Trust beneficiaries” to purchase her half-interest in RiverCliff after the couple divorced. Throughout this time, Talmage resided at RiverCliff.

Unlike the debtors in the bankruptcy cases linked above in which the issue was a clawback of money paid to the IRS, here the perpetrator of the scheme also failed to pay his taxes. Because he failed to pay his federal taxes, the IRS filed a notice of federal tax lien. The lien attached to RiverCliff and all of the property owned by Mr. Talmage. The IRS brought suit to foreclose its lien on the property. The Recovery Trust sought to intervene in that action and was denied. The Recovery Trust then brought this action seeking to quiet title to the property. At the district court level the IRS succeeded in having the suit dismissed. The referral to the Oregon Supreme Court comes because the Ninth Circuit sees the possibility that under Oregon law the Recovery Trust may have a superior property interest to the lien of the IRS.

Although the priority of the federal tax lien is determined under federal law, whether the taxpayer has a property interest to which the lien can attach is a question of state law. Looking at Oregon law, the Ninth Circuit found that opinions existed supporting both the majority and minority views of constructive trust:

The rights of the legal title-holder, and of lienors such as the Government, depend on when the constructive trust arises. Under the laws of the several states, a constructive trust can arise either at the moment a purchase is made with the fraudulently-obtained funds, or at the moment a court imposes the trust as an equitable remedy. Under the majority rule, a trust arises automatically at the moment of purchase. See In re Leitner, 236 B.R. 420, 424 (Bankr. D. Kan. 1999) (“[U]nder the majority state law rule, a constructive trust arises at the time of the occurrence of the events giving rise to the duty to reconvey the property, not at the date of final judgment declaring the trust . . .”); see also RESTATEMENT (THIRD) OF RESTITUTION AND UNJUST ENRICHMENT § 55 cmt. e (2011). In states following this rule, the legal title-holder is a constructive trustee who holds no rights beyond bare legal title. For purposes of the federal tax lien statute, 26 U.S.C. §6321, property held in a constructive trustee-taxpayer’s name therefore does not “belong” to the taxpayer, and tax liens cannot attach. See, e.g., FTC v. Crittenden, 823 F. Supp. 699, 704 (C.D. Cal. 1993) (finding that an “IRS lien does not attach” to business funds that are subject to a constructive trust under California law); Mervis Indus., Inc. v. Sams, 866 F. Supp. 1143, 1147 (S.D. Ind. 1994) (finding tax liens could not attach to property whose title is held by an embezzler because Indiana law “is clear” that “an embezzler, from the beginning, acquires no beneficial ownership in property purchased with stolen funds”).

Under the minority rule, a constructive trust arises only once it is imposed as a judicial remedy. In that case, the legal title-holder retains all the rights of a property owner until such a remedy is imposed by a court. Until that time, the property “belongs” to the title-holder for purposes of 26 U.S.C. § 6321 and federal tax liens against the title-holder can attach. If no court has imposed a trust when the tax liens attach, the beneficiaries of a potential constructive trust hold at most an inchoate claim to the property. For example, in Blachy v. Butcher, 221 F.3d 896, 905 (6th Cir. 2000) (quoting Soo Sand & Gravel Co. v. M. Sullivan Dredging Co., 244 N.W. 138, 140 (Mich. 1932)), the Sixth Circuit found that “[u]nder Michigan law, a ‘constructive trust is strictly not a trust at all, but merely a remedy administered in certain fraudulent breaches of trusts.’” Because “a constructive trust does not arise until a judicial decision imposes such a trust under Michigan law,” beneficiaries of the trust alleged in that case held only an inchoate state-created lien, over which an attached federal tax lien takes priority. Id.

Because state law controls a critical question concerning the competition between the parties due to the issue of what property interest in the taxpayer held, the Ninth Circuit correctly certified the question to the Oregon Supreme Court. The specifics of Oregon law may impact few readers but the issue of constructive trust and the ways that states have construed ownership in these situations has broad application. The lawyers for the trust have done a great job of keeping the case going in the face of significant adversity after being rebuffed in their effort to intervene and being dismissed in the quiet title action. They have one more hurdle to leap before the defrauded investors (and probably the lawyers themselves) have a chance at using the value of the property purchased by Talmage to satisfy their claims.

Ninth Circuit Affirms Earlier Decisions Denying Debtor Right to Alter IRS Lien after Bankruptcy

On November 7, 2017, I posted on the case of In re Nomillini in which the debtor sought to limit the secured claim of the IRS based on the confirmation of his chapter 13 plan. The Ninth Circuit, in an unpublished opinion dated December 18, 2018, denied the debtor’s motion to cut off the rights of the IRS lien in debtor’s property. Here, the debtor’s plan did not seek to limit the rights of the IRS as a secured creditor. The court relied on the normal rule that a lien against a debtor passes through the bankruptcy unaltered absent a specific attack on the lien as a part of the bankruptcy proceeding.

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The Ninth Circuit stated the general rule as follows:

For a debtor to avoid a creditor’s lien or otherwise modify the creditor’s in rem rights, the debtor’s confirmed plan must do so explicitly and provide the creditor with adequate notice that its interests may be impacted. Id. at 873. Any ambiguity in the plan will be interpreted against the debtor. Id. at 867.

Mr. Nomillini did not mention the IRS lien in his chapter 13 plan. He gave no notice to the IRS during his bankruptcy proceeding that he sought to reduce or eliminate its lien on his property. He sold his home. He entered into an agreement with the IRS that its lien would attach to the proceeds. The sale of the home brought a greater price than anticipated by the IRS when it filed its original lien. Based on the sale price, the IRS amended its claim to increase the amount of its lien claim to match the proceeds. Mr. Nomillini sought to limit the IRS lien claim to the amount of the original claim. He then brought an action seeking to avoid the IRS lien to the extent that it exceeded the original claim. The lower courts dismissed the case and the 9th Circuit affirmed.

Lien claims not only pass through bankruptcy unimpacted (absent a specific challenge) but the amount of a lien claim can change during or after a bankruptcy as the value of the property increases or decreases. When the IRS filed its original claim in this case, it had to value its lien claim and claim any portion not covered by equity in Mr. Nomillini’s property as an unsecured claim. Here, the value of the secured property turned out to be low either because the IRS made a wrong determination at the outset or because the property continued to increase in value. In either event the debtor does not receive a windfall because of the low value in the initial claim.

Once the property was sold, the value of the property was set and the IRS amended its claim up to the amount of the sales proceeds. The Ninth Circuit joins the lower courts in determining that the IRS has the right to do this. Had the property sold for less than the amount of the lien claim that the IRS made, the value of the lien claim would have decreased rather than increased. For this reason creditors often seek to protect themselves from a downward movement of value in secured property by seeking adequate protection. The IRS does not do this often because of the time involved to seek adequate protection and, in cases in which its lien is secured by real property, because of the difficulty in proving that the property will decrease in value.

The case resolves the issue in a manner consistent with existing law. The lesson here is that the value of a lien claim is not fixed at the time of filing bankruptcy.