As we have mentioned on many occasions, Les suggested that we start this blog because of the work we do to update the treatise “IRS Practice and Procedure.” At the moment Marilyn Ames, my former colleague in IRS Chief Counsel and occasional guest blogger, and I are updating and rewriting Chapter 16 of the treatise dealing with the priority of IRS debtor over other creditors. In updating the chapter Marilyn found several important cases in the area of the priority of IRS debt for insolvent debtors which we have not written about on the blog. In this post she discusses several of these cases as well as the general background of the insolvency procedures. For those of you who use the treatise or who may consider using it in the future, look for major changes to Chapter 16, including major changes to the bankruptcy section, in the next several months. Keith
Lurking in Title 31 of the United States Code is an unpleasant surprise for all creditors whose debtor also owes a debt to the United States. This provision, located at 31 USC § 3713 and known as the Federal Priority Statute, has been in force without material change since 1797, and was held to be constitutional in 1805 in United States v. Fisher, 6 US 358 (1805). This statute provides that when a person indebted to the United States is insolvent and some action occurs such as the debtor making a voluntary assignment of his property that threatens the government’s ability to collect its debt, or when a deceased debtor dies and the property of the estate is insufficient to pay all the debts of the debtor, the claim of the United States is to be paid first. Section 3713 does not create a lien; the government’s priority is created solely by the statute. The only statutory exception in Section 3713 was added when the Bankruptcy Code was passed to provide that Section 3713 does not apply in a bankruptcy case brought under Title 11.
To create an incentive for the United States to receive its priority payment, the fiduciary holding the property of the person or administering the debtor’s estate can be held personally liable if the claim of the United States cannot be paid in full after the fiduciary pays any other debt over which the United States’ claim has priority, provided the fiduciary knew about the debt to the United States when the payment to a lesser creditor was made.
When the claim owed to the United States originates within the Internal Revenue Code, Section 3713 is not as easily applied as appears on its face. Congress later provided protection to third parties, including creditors, against the vast reach of the federal tax lien that arises when a tax debt has been assessed and remains unpaid when it passed the Federal Tax Lien Act of 1966, codified in Section 6324. In Section 6324 of the Internal Revenue Code, Congress listed various parties who should be given a priority position against a tax debt. So, when the stars align and both the United States and a private creditor claim priority to a debtor’s limited assets under these competing statutes, who should be paid first? In United States v. Romani, 523 US 517 (1998), the Supreme Court addressed this and held that Section 6324 represented Congress’s judgment as to when a federal lien for unpaid taxes is not valid against certain third parties, and that Section 3713 should yield to this later Congressional act when there is not enough money to pay both the United States and the third party.
The courts have also created judicial exceptions that limit the reach of the Federal Priority Act. The costs of administering the estate of the debtor may be paid before a tax claim, including such expenses as court costs and reasonable compensation for the fiduciary and other professionals such as attorneys. Funeral expenses and spousal allowances have also been allowed before the government’s claim. However, in United States v. McNicol, 118 AFTR2d 2015-5150, 829 F3d 77 (1st Cir. 2016), the court held that the fiduciary must be able to show that the property transferred was used to pay these expenses.
So what is a fiduciary to do when it is unclear who the debtor’s limited funds should go to? One popular remedy is to file an interpleader action, joining all possible adverse claimants to the funds, and allow the court to sort out the priorities. This procedure is illustrated in the case of Karen Field, Trustee of Deshon Revocable Trust v. United States, 129 AFTR2d 2022-1007 (ED Ca. 2022), in which the court determined who had priority to the funds and in what order the claims should be paid – or remain unpaid. In this case, the decedent had embezzled funds, taxes were owed on the embezzled money to both the federal and state governments, and the victims of the embezzlement wanted to be repaid. The Department of Justice Tax Division has a directive that when the tax claim and the claim of the victims of embezzlement arise from the same transaction and the funds at issue can be traced to the victims’ property the victims should be paid before the tax claim. Despite this directive, the court applied Section 3713 and gave the tax claim priority, holding that the directive in question is merely internal agency policy, and not a source of enforceable legal rights for the victims. The procedural aspects of an interpleader action are also illustrated in Findling v. United States, 121 AFTR2d 2018-1450 (ED Mich. 2018).
In another case involving government policy, the court took a contrary position in Estate of Graham v. Wells Fargo Bank, 2022 WL 2300940 (Cal. App. 3 Dist. 2022), when the executor of an estate asked the trial court to determine the order in which the proceeds from sale of a piece of estate property should be distributed. The executor requested that the federal taxes be paid first pursuant to Section 3713, but the court held that the federal taxes did not take priority over a purchase money security interest with respect to the property in question. Although Section 6324 says nothing about purchase money security interests, the Service announced in Rev. Rul. 68-57, 1968-1 CB 553 (1968) that a perfected security would be given priority over a federal tax lien with respect to the property the loan was used to acquire. Accordingly, the claim of the bank advancing the money for purchase of the property should be paid before the federal tax liability.
The potential danger to a fiduciary in not paying a tax claim entitled to priority is illustrated in the recent case of Estate of Lee v. Comm’r of Internal Revenue, 2022 WL 3594523 (3rd Cir. 2022), a CDP case in which 3713 played a pivotal role. The estate taxes owed by the petitioner in this case had been miscalculated, resulting in a deficiency, and the estate requested that the Internal Revenue Service accept an offer-in-compromise as the estate assets had been distributed to the beneficiaries, including over $640,000 paid out after the notice of deficiency was issued. The Service rejected the offer made, taking the position that the reasonable collection probability was greater than the amount offered. The Tax Court agreed that the IRS did not abuse its discretion in rejecting the OIC, and the Third Circuit agreed, pointing out that the government could seek to collect from the fiduciary, who had distributed assets after learning of the tax claim and so could be held personally liable.
For a statute that clearly states that the United States should be paid first, and that a fiduciary who fails to do so may need to pay the claim from the fiduciary’s funds, Section 3713 is not as clear as a mere reading would make it seem. Given the holding in Estate of Romani, the judicially created exceptions for administrative expenses, and the question of whether a government policy directive waiving the right to payment first applies – or doesn’t – any professional even dealing tangentially with insolvent debtors or estates should be familiar with the existence of Section 3713 and its implications on when the United States should be paid before other creditors.