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.
read more...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 Date | Tax | Interest on Tax | Penalty |
| 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.
What about the homestead exemption? That would have protected any unprotected equity from unsecured creditors so why isn’t it mentioned in the opinion? This could be a big hit for debtors and I think it’s a very important issue. Any thoughts?
Nic
I’ve seen cases where the debtor claimed a homestead exemption in an effort to keep the 724/726(a)(4) “equity” out of the hands of unsecured creditors. If the trustee can’t touch this equity because of the homestead, the IRS lien trumps the homestead. Debtor loses either way. There shouldn’t be any dispute about such a result.
Maybe others can expand on my response and provide greater practical detail. The homestead exemption does not impact the federal tax lien. The IRS can reach property that they debtor might otherwise protect with the homestead exemption because the federal tax lien is not impacted by this exemption. My belief without going to search for an answer is that because the homestead exemption provides no protection from the federal tax lien when the trustee uses 724 to bring property secured by the federal tax lien into the estate for the benefit of unsecured creditors the money that would have gone to the IRS goes to the unsecured creditors and not to the taxpayer based on a homestead exemption. If the homestead exemption applied in this situation you would essentially be setting up a circular priority problem. The IRS defeats the tax debtor, the unsecured creditors in the right situation defeat the IRS and the debtors defeats the unsecured creditors by virtue of the homestead exemption. The goal of 724 is to put into the hands of unsecured creditors money that the debtor would lose anyway because the tax lien defeats the homestead exemption. The debtor is no worse off because of the existence of 724. If Congress wanted this benefit to go to the debtor instead of the unsecured creditors it would have written the law to have the homestead exemption apply to the federal tax lien. It didn’t write it that way.
I understand the tax lien trumps the the homestead exemption, and that has always made perfect sense. My concern is that once a lien is avoided it’s gone. So to the extent there is no lien the homestead exemption should take first priority over unsecured creditors. I don’t see an issue with the trustee using this arithmetic to create a return to unsecured creditors, but it should be done AFTER the homestead is applied to the unsecured equity otherwise the public policy behind homestead exemptions is totally leap frogged. I think it’s a concerning result.
As a side note, in the case cited, shouldn’t the tax lien(s) recorded on 5/23/11 be treated as one lien? It’s all one one document with no “priority” going to one over the other. So why not add the two liens together for the tax/interest portion and then the penalty portion to do the math on what can be avoided? Why are they moving down line by line on the actual lien document itself?
Never mind on the first part of the last comment. I guess if the trustee steps in the shoes of the lienholder which technically would give them priority over the homestead. Sorry for sounding foolish on that.
But I’m still curious on the second part of my comment. Is the tax lien document considered multiple liens based priority of each line over the other? Or is one document recorded for multiple years filed on the same day considered one lien?
The opinion does not provide enough detail to allow me to know the court’s thinking on this. On a typical notice of federal tax lien several periods might be listed. I do not know how this court would parse different periods displayed on the same notice. It’s clear that the IRS would argue that if multiply periods exists on one notice the IRS would argue that the document should be considered in the whole. My guess is that this court might treat the periods from the oldest to the newest.
Here in SoCal, this issue comes up with some regularity. I (and others) have always been able to negotiate a resolution of this issue with IRS and CA tax agencies. Which is why there isn’t any real case law locally here.
My sense is that there quite a few people out there who don’t pay enough attention to the effect of section 726(a)(4). It can even cast a long shadow over chapter 11 cases if the facts are right. Lack of attention may also partially explain the absence of case law.
The lien document is only notice of the existence of an already-extant lien. If tax periods are going to be lined up in order of priority, perhaps date of assessment would be the way to go.
Note that the United States appealed to the Ninth Circuit on June 30th, so this is probably not the end of the story.
FYI, Lavar called the eventual outcome on the exemption issue. In re Hutchinson, 15 F.4 1229 (9th Cir. 2021). The case is 9th Circuit docket number 19-60065.