In the case of In re Morgan, No. 21-50455 (M.D.N.C. 2021) the bankruptcy court sustained an objection by the trustee to the exemptions claimed by the debtor. The basis for the objection was that even though the debtor owned certain property in the form of tenancy by the entireties he could not escape the federal tax lien. The holding is consistent with prior case law and shows the power of the federal tax lien versus other types of liens. The Supreme Court’s decision in Craft v. United States, 535 U.S. 274 (2002) continues to make a significant difference for debtors living in states with strong tenancy by the entireties laws which, prior to Craft, provided protection from this impact of the federal tax lien. Because of the treatment of secured property of tax creditors in B.C. 724, Craft benefits not only the IRS but certain unsecured creditors. In this case the trustee seeks to establish the lien interest of the IRS not for the benefit of the IRS but for these other creditors who, but for the ability of the federal tax lien to reach this type of property interest, would have no ability to do so.
read more...Mr. Morgan filed a chapter 7 petition on July 16, 2021. Mr. Morgan filed bankruptcy only for himself even though he was married at the time of the filing of the bankruptcy petition. At the time of filing he owned a home in North Carolina with his wife. As is standard in home ownership of married couples in states like North Carolina with tenancy by the entireties, they held the home with that form of ownership. Because of the form of ownership, Mr. Morgan argued that the home did not become property of the bankruptcy estate and even if it were property of the bankruptcy estate, the trustee could not stand in the shoes of the IRS.
For readers not familiar with tenancy by the entireties, it developed under English common law as a way to protect the wife at a time when a wife’s ability to own property had significant limitations and it shields property owned in this manner from the debtors of only one member of the marital unit. Prior to the decision in Craft, almost all courts looking at the impact of the federal tax lien on property held in this manner found that the IRS could not reach the property because of the state law restrictions placed on creditors seeking to pursue collection from tenancy by the entireties property. Read Craft if you want to know more about this type of ownership and why the Supreme Court found that it did not prevent the federal tax lien from reaching the interest of one member of the marital unit in the property.
Because of Craft, the trustee argues that the “Property was not exempt from process by the IRS prepetition and is thus not exempt in bankruptcy to the extent of the IRS debt.” The debtor sought to exempt the property from the bankruptcy estate under B.C. 522(b)(3) if the property did come into the bankruptcy estate as property of the estate.
The bankruptcy court quickly knocks out Mr. Morgan’s argument that tenancy by the entireties property does not come into the bankruptcy estate citing to cases decided before Craft involving creditors other than the IRS. Just because the property comes into the bankruptcy estate, however, does not mean that the debtor cannot claim the property as exempt. After deciding the home because property of the bankruptcy estate, the court examined Mr. Morgan’s claim of exemption under B.C. 522(b)(3) which provides:
[A]ny interest in property in which the debtor had, immediately before the commencement of the case, an interest as a tenant by the entirety or joint tenant to the extent that such interest as a tenant by the entirety or joint tenant is exempt from process under applicable nonbankruptcy law . . . [emphasis added in the opinion]
The bankruptcy court looked at non-bankruptcy law in deciding if Mr. Morgan’s interest in the home met the test of “exempt” or “immune” from process. Here, Craft comes into the picture. The court notes that North Carolina follows the common law rule that tenancy by the entireties property is exempt from the claims of non-joint debt creditors. Because of the phrase “applicable non-bankruptcy law” the court looks to federal as well as state law regarding the ability to collect from this property and finds that pursuant to Craft the federal tax lien attaches to Mr. Morgan’s interest in the property despite the state law provisions which would prevent that attachment.
Consequently, the IRS debt for which the Debtor was liable prepetition is not immune or exempt from process under applicable nonbankruptcy law. When the Debtor failed to pay his taxes, the statutory tax lien under 26 U.S.C. § 6321 arose and attached to the Debtor’s interest in the Property, and as he had not satisfied that liability prior to the bankruptcy filing, that lien remains in place. The Debtor’s entireties interest is thus not exempt from process by the IRS. See In re Sanner, 2005 WL 6761125, at *3 n.2; see also Conrad v. Schlossberg, 555 B.R. 514, 520 (D. Md. 2016) (finding debtor’s interest as tenant by the entirety is not exempt from process where the United States obtained a restitution judgment and lien under 18 U.S.C. § 3613).
So, the property fails to meet the necessary exception which would have allowed it to be exempt from bankruptcy estate after coming into the estate. Next, the court finds that the trustee has the power to assert the IRS lien interest for the benefit of the estate. Although the court does not get to this point, the impact of the decision will allow some unsecured priority creditors who otherwise probably would not have been paid by the bankruptcy estate to receive a distribution. The IRS may receive a small benefit from this decision but the bulk of the benefit probably will go to other creditors and to the trustee. Because some of the debt in the IRS lien had priority status and will not result in a discharge for Mr. Morgan, it is possible that this decision will cause him to continue to owe money after the bankruptcy case because some non-dischargable taxes will pass through the bankruptcy without being paid and without being discharged.
Hi Keith, good and useful post. You say twice that the main beneficiaries of this holding will be unsecured priority creditors other than the IRS. Is that because the IRS never filed an NFTL and so is also an unsecured creditor, standing 8th in priority line per section 507? Or is it because of section 510? Or some other reason?
Read 11 USC Section 724(b) and the cases thereunder.
Bryan – Two others have responded and provided the answer before I could get to this but Congress allows the taking of money from the government, since it can do that without any constitutional problems, through BC 724. Essentially the lien interest of the IRS is used to pay priority creditors under the statutory scheme. I should have made that clearer in the post.
How does this decision vary from IRS Chief Counsel Notice 2003-60?
Because the trustee will only get half of the proceeds attributable to the husband’s interest the decision is in sync with Craft and with the notice.
11 USC Sec 724(b). Trustees also use Sec 724(a).
I have limited posting ability today. When I have a better set up, I can provide more info.
My follow up. Under § 724(b), the trustee may avoid the entire lien but the proceeds must be used to pay priority claims. Under § 724(a), the trustee may avoid the penalty portion of the lien for the benefit of all creditors. IMO, you are more like to see avoidance under § 724a).
I like to think of the avoidance under § 724(a) as less broad but a larger class of creditors benefit. Under § 724(b), the avoidance is of the entire lien, but the class that benefits is limited to priority creditors.