In United States v. Warfield (In re Tillman), No. 21-16034 (9th Cir. 2022) the Ninth Circuit reversed the lower courts and determined that the chapter 7 trustee could not avoid the federal tax lien on the debtor’s homestead. The trustee filed a motion for rehearing en banc and the 9th Circuit has ordered a response from Appellant by December 4. A copy of the response is attached here. So, the discussion below may not be the end of the story.
Ms. Tillman purchased a house in Prescott, Arizona. Prior to the filing of the bankruptcy petition the IRS filed a notice of federal tax lien on the property stemming from a penalty she owed. Ms. Tillman claimed a $150,000 homestead exemption in the house under Arizona law. The trustee sued to avoid the tax lien on the exempt property in order to obtain the benefit of the lien for the bankruptcy estate. At the time of the bankruptcy, she had paid off the underlying taxes set out in the lien notice but owed about $25,000 in penalties.
The issue pits different bankruptcy codes sections against each other that deal with exemptions and with the treatment of penalties in chapter 7 cases.
BC 522 generally permits a debtor to claim certain property as exempt. The amount of property is almost always dictated by the state in which the debtor lives at the time of filing bankruptcy. Arizona has a generous homestead provision which Ms. Tillman claimed. Under almost all circumstances a debtor gets to keep the exempt property which cannot be used to satisfy the claims of creditors in the bankruptcy case; however, claiming property as exempt protects it from the claims of unsecured creditors not those who have a security interest in the property claimed as exempt.
BC 522(c)(2)(B) holds that exempting property does not protect it from a tax lien where the IRS has properly filed the notice before the bankruptcy petition. The notice of federal tax lien would not specifically mention a taxpayer’s real estate but attaches to all property and rights to property belonging to the taxpayer. To perfect the lien against a taxpayer’s real estate, the IRS would need to file the lien in the locality in which the property was located. If, prior to the filing of a bankruptcy case, the IRS filed the notice in the city or county in which the property was located and if the notice properly identified the taxpayer, the IRS would have a perfected lien that would survive the debtor’s attempt to claim the property as exempt. It would not receive payment for its lien in the bankruptcy case but would have the ability to pursue the property after bankruptcy. Because the IRS is reluctant to administratively or judicially take taxpayer’s homes, sometimes taxpayers get to keep their homes safe from other creditors because of the federal tax lien’s priority, and then the IRS never pursues the property allowing some lucky taxpayers to walk away from both their tax obligations and their other debts.
Chapter 7 trustees do not have the same reluctance or policies regarding debtor’s homes that the IRS does. The trustees carefully review debtor’s schedules and other available information to determine if selling the debtor’s home or other assets would bring a benefit to the unsecured creditors of the bankruptcy estate (as well as a commission to the trustee.) Here, the trustee sought to use the existence of the tax lien combined with BC 724 and 726(a)(4) to sell the property for the benefit of the unsecured creditors.
BC 724(a) says that a chapter 7 trustee can avoid a “lien that secures a claim of a kind specified in section 726(a)(4)” for the benefit of the estate. BC 726 describes how property in a chapter 7 case should be distributed to creditors, providing first for claims listed in BC 507 which would include the unsecured claims to which Congress has given priority, second to unsecured claims with no priority, third to unsecured claims filed late, and fourth to claims for penalties, whether secured or unsecured.
The trustee reasoned that because the underlying tax had been paid, the IRS’s claim (secured by the notice of federal tax lien) was merely a claim for a “penalty” within the meaning of BC 726(a)(4), and therefore under BC 724 the lien could be avoided. The bankruptcy code disfavors penalty tax claims allowing the avoidance of the liens for these claims through the procedures described in BC 724 and 726.
However, the trustee had one more hoop to jump through: under BC 551 the property preserved must be property of the estate. This requirement was key to the government’s argument. Section 551 comes immediately after the bankruptcy code provisions allowing for the avoidance of certain transfers. It seeks to preserve the property avoided for the bankruptcy estate unless the property would not have met the definition of property of the estate described in in BC 541. In other words, the avoidance provisions cannot transform property that would otherwise have remained outside the estate into property of the bankruptcy estate.
The bankruptcy and district courts held that the trustee could avoid the federal tax lien, rejecting:
The government’s argument that the court’s holding would cause inequitable results for the Debtor, because the Debtor’s exemption could be reduced twice as a result of the same lien—first, as a deduction from the amount that Debtor could exempt, and then, again, when the Debtor is required to satisfy the value of the lien to the IRS. The Bankruptcy Court reasoned that the Debtor would not have to unfairly pay twice on the same lien because the IRS Tax Lien “never attached to the Debtor’s homestead exemption.” “[T]he value of the Debtor’s exemption was always subordinate to the Tax Lien” and “[w]hen the Tax Lien is avoided, the Trustee steps into that avoided position.” Therefore, the court explained, “[i]f it so happens that the IRS’s now unsecured claim is also nondischargeable, it is no different than any other nondischargeable claim which will need to be paid by the Debtor.”
Essentially, the IRS argued that the debtor’s homestead exemption withdrew the exempt property from the bankruptcy estate which would mean it is unavailable for the unsecured creditors of the estate. The Ninth Circuit finds that:
When a debtor properly exempts a property interest under § 522, the exemption withdraws that property interest from the estate and, thus, from the reach of the trustee for distribution to creditors….
In reaching our holding, we conclude that the Bankruptcy Court erred by overlooking the key question of first impression before us: whether a trustee may use § 724(a) to avoid a lien secured by a debtor’s exempt
property. The Bankruptcy Court did not analyze this question. Instead, the Bankruptcy Court appears to have assumed that the Trustee could use § 724(a) to avoid a lien on the Debtor’s exempt property.
The majority was especially concerned that its result kept the debtor from having to pay the debt twice. The majority took pains to distinguish the decision in Hutchinson v. IRS (In re Hutchinson), 15 F.4th 1229 (9th Cir. 2021). I wrote about the bankruptcy and district court opinions in that case here and here. It’s difficult to find a light of daylight between the two opinions except that the government did not raise the issue in Hutchinson but merely conceded that the result the trustee sought could attach.
I agree with the majority in Tillman. While it may look like the avoidance provision seeks to preserve property for other creditors, in this instance applying the law as was done in the lower court opinions puts debtors in the bad position of paying twice since the exempt property will now be used to pay unsecured creditors who would otherwise not have the opportunity to get paid from this property while the debt owed to the IRS is not extinguished and can be collected after the bankruptcy. The existence of the tax lien should not create a benefit for the unsecured creditors.
The dissent looks to the powers of the trustee to avoid liens and to the position of the IRS when it has a lien claim. It finds the majority’s concern with the consequence of avoidance of the lien to be a troubling result does not matter because what matters is the language of the bankruptcy code. The defense finds that the plain text supports the position of the lower courts.
Contrary to the IRS and majority’s view, the trustee’s authority to avoid a federal tax penalty lien isn’t nullified because it encumbers exempt property. The majority incorporates § 726’s reference to the distribution of the “property of the estate” to bar a trustee’s avoidance authority. The IRS instead relies on § 551’s limitation of preservation of liens “only with respect to property of the estate.”
This issue will not go away easily and may soon result in a successful Supreme Court petition.
Ken Weil, who knows a lot more about tax issues in bankruptcy than me and who occasionally writes guest posts for PT, sent me this case. When I sent him my draft, he offered these comments which provide a slightly different, and probably better, perspective on the case:
The IRS objected to the trustee’s use of BC 724(a), presumably because it determined that collection of the nondischargeable tax penalty would be more difficult without the NFTL attached to the property. The tax year at issue was 2015. The taxpayer filed for bankruptcy in January 2019. Tax penalties in Chapter 7 are dischargeable after three years from the due date of the return, including extensions, for the failure to file penalty, or three years from the payment due date for the failure to pay penalty. BC 523(a)(7); and see United States v. Wilson, No. 15-1448, Docket entry No. 10 (N.D. Cal. 2016) (opinion withdrawn as parties settled) (tax year at issue 2008; petition filed July 2012; 2008 return filed on extension; parties agreed that failure-to-pay penalty was discharged; held, failure-to-file penalty not discharged). One has to wonder why the bankruptcy filing was not delayed until after April 15, 2019, at the least.
The IRS argued that exempt property is not property of the bankruptcy estate. Schwab v. Reilly, 560 U.S. 770, 775-776 (2010). For avoidance to be available to the trustee, BC 724(a) and 551 require that the property in question be property of the bankruptcy estate.
More precisely, an exempt interest in property is not property of the bankruptcy estate. Schwab v. Reilly, 560 U.S. 770, 794-795 (estate retained interest in property beyond the exempt amount) (2010). In other words, while the value of the homestead left the bankruptcy estate, the rest of the house remained in the bankruptcy estate. In that situation, what is the property of the estate? Does the trustee have the authority to use BC 724(a) if the part of the real property against which the trustee can avoid the IRS lien is out-of-the-bankruptcy estate yet the property itself remains property of the bankruptcy estate? Without diving into the Schwab v. Reilly issue, the Circuit Court found that the applicable property interest was not property of the estate, and BC 724(a) was not available to the trustee. The dissent felt that the house was property of the estate, and, under the literal terms of the statute, the IRS lien could be avoided.
As a policy matter, the IRS argued, and the lower courts agreed, that allowing the trustee to avoid the lien as to the homestead would cause a double payment by the taxpayer. This is a true statement, but also this argument is a red herring. If the secured tax obligation is nondischargeable, there is always the potential for a double payment, regardless of whether the property at issue is exempt property. The first payment is made from property that otherwise would have paid the tax debt, and that money is spread among all creditors. The second payment potentially comes postpetition from the debtor to the taxing authority because the debtor’s tax obligation was not discharged.
Here, the trustee could have potentially avoided the issue at-hand by timely filing an objection to the homestead exemption. Then, the argument as to whether the homestead interest had left the bankruptcy estate would not have been available. Instead, the argument would be whether the trustee can object to the exemption because the trustee has rights in the property under BC 724(a).
Ken also offered the following fact pattern as a way to think about the problem:
>Files for bankruptcy;
>Taxpayer has a nice car;
>Taxpayer makes a claim of exemption in an interest in that car, which exemption claim does not cover the entire value of the car, and the trustee does not object; and
>The IRS only has a FTL and not a NFTL.
The claim of exemption would scrub the FTL from that interest in the car but the FTL would remain attached to the rest of the car, which is property of the bankruptcy estate and subject to the trustee’s control.
Don’t know that there is anything to come of this because the trustee can avoid the FTL. But, I suppose the trustee could decide the car was not worth administering and abandon it. Then, the debtor gets the car back, and it is partially lien-free and partially subject to the FTL.