The case of Hutchinson v. United States [No. 17-01076] (E.D. Cal. 2017) involves an effort by taxpayers in bankruptcy to avoid a federal tax lien securing the payment of penalties. The bankruptcy court denies the effort by the taxpayers to avoid the lien while acknowledging that the bankruptcy trustee could have avoided the lien had the trustee sought to do so. As discussed below, the reason that the bankruptcy court allows one party, the trustee, to avoid a federal tax lien securing penalties but not another party, the debtor, results from the benefit Congress sought to confer in allowing avoidance of the federal tax lien securing penalties in a chapter 7 case.
The taxpayers owed $162,690 in penalties at the time they filed their bankruptcy petition. Prior to the filing of the petition, the IRS had filed a notice of federal tax lien in the city or county in which their residence was located. In their bankruptcy schedules, taxpayers indicated that the value of their home was $185,000 and that it was encumbered by a first deed of trust in the amount of $87,000. They claimed a personal exemption of $100,000. Because they lived in California, which has a generous exemption provision for personal residences, this was possible. Not all states have such a large exemption for personal residences.
Taxpayers’ problem with the exemption was that it removed the property from the bankruptcy estate allowing them to keep the property and the home equity; however, the federal tax lien continued to attach to the property after bankruptcy putting them in the position of going through the bankruptcy only to find that on the other side they had not obtained the relief they needed. Because the federal tax lien still attached to the home, the IRS had/has the ability to sell the home either administratively or through a foreclosure proceeding. The taxpayers presumably sought to avoid the lien in their case in a post bankruptcy discharge action in order to keep the IRS from taking their home and using the equity in excess of their first mortgage to satisfy the tax debt.
Before discussing the Hutchinsons’ case further I stop to note that the IRS is generally very reluctant to take taxpayers’ homes. Before 1998 it did not take taxpayers’ home frequently, but after the Restructuring and Reform Act of 1998 the IRS very rarely takes taxpayers’ homes or other tangible property. The situation gets a little stickier for the IRS in the post bankruptcy situations. Absent bankruptcy, the IRS can simply take no collection action operating under the fiction that the statute of limitations on collection is still open and it might collect from the taxpayers through some mechanism other than seizure and sale of property. No one at the IRS is forced to make a decision concerning collection and the general practice of only seizing tangible assets in rare circumstances usually results in a decision to do nothing which is different than an affirmative decision to walk away from the only property that could satisfy the liability.
When a taxpayer obtains a bankruptcy discharge and before the filing of the bankruptcy petition the IRS a filed federal tax lien for the discharged taxes discharged, someone at the IRS must make an affirmative determination whether to pursue collection from any assets the taxpayer brought into the bankruptcy estate to which the federal tax lien attached. The equity available in a debtor’s property such as the home equity available in the Hutchinsons’ case is the only thing from which the IRS can collect to satisfy the discharged liability because the bankruptcy discharge turned what was an in personam liability into an in rem liability. The rem, or the thing securing the debt, in the Hutchinsons’ case, their house, is the only asset the IRS has from which it can satisfy the liability. Someone at the IRS must make an affirmative determination to release the lien. In this situation the IRS employee assigned to the case cannot rely on the fiction that the IRS might later collect the liability from future earnings or a voluntary payment. The IRS employee knows that if they release the lien they are walking away from $100,000 in equity and that the only way to collect the $100,000 is to enforce the lien on the property. Here, it becomes more likely that the IRS will take action against the property to obtain the equity to which its lien attaches than if the taxpayer had not sought bankruptcy relief.
So, the Hutchinsons would like to eliminate the IRS lien in order to eliminate the possibility that the IRS would take their home. Because the lien at issue here is a lien in which the underlying liability is a penalty and not a tax and because the taxpayers filed a chapter 7 petition, the trustee could have avoided the lien using the powers available in Bankruptcy Code sections 724(a) and 726(a)(4). The Hutchinsons brought this action to avoid the penalty under Bankruptcy Code section 522(h). Section 522 is the section that addresses exempt property. The IRS responded to the action by arguing that 522(c)(2)(B) specifically allows it to assert its lien against exempt property and that only the trustee has standing to assert the lien avoidance provisions of 724(a).
The court acknowledged that the trustee could have avoided the tax lien and then found that if the trustee does not do so debtors can avoid liens under section 522(h) but not tax liens. Citing the earlier Ninth Circuit case of In re DeMarah, 62 F.3d 1248,1250 (9th Cir. 1995) the court holds that “where the lien sought to be avoided secures back taxes, 522(c)(2)(B) eviscerates the debtors’ 522(h) powers.” The court noted that the fact that the debtor could exempt property from the estate does not mean that the debtor can remove the lien “or that portion of it which secures the penalty.” The purpose for allowing the trustee to avoid the tax lien securing penalties in a chapter 7 case is to allow the trustee to obtain a greater recovery for the benefit of the other creditors of the bankruptcy estate. The purpose of the provision allowing avoidance was not to allow the debtor to gain relief.
This case does not break new ground but presents a bankruptcy issue we had not previously discussed on the blog. The penalty avoidance powers in chapter 7 are strong and represent an effort by Congress to clear up some equity for other creditors who should not be penalized themselves by the debtors’ bad tax behavior. The provision allows the removal of the lien on penalties as an impediment to the payment of a creditor with no lien interest or an inferior lien interest and avoids having limited estate funds go to satisfy a debt based on bad behavior towards the IRS. Those avoidance powers were not intended to allow the debtor to use bankruptcy to escape from their bad tax behavior. In the absence of a filed federal tax lien and if the penalty is not for fraudulent behavior, bankruptcy serves as an excellent mechanism for discharging penalties more than three years old but the existence of the filed federal tax lien changes the game and gives the IRS the opportunity to pursue available equity in a debtor’s property to collect penalty claims if it has the desire to do so.