On February 25, 2014, the Ninth Circuit affirmed the Tax Court’s decision in a CDP case holding that the IRS may levy upon the pension of Stuart Gross. The case presents procedural issues in both the tax and bankruptcy codes. Both the IRS and the taxpayer made mistakes that could have caused the case to turn out differently. I will focus more on the lien issue but the bankruptcy issue matters very much as well.
Mr. Gross ended up with a sizable tax liability for the years 1998, 1999, 2000, and 2001. The opinions in the Tax Court and the 9th Circuit do not describe how the liabilities came into existence. I always like to know how someone ends up owing over $270,000 as it influences my sense of fairness in the outcome. When the students in my clinic submit an offer in compromise, we explain in detail how the taxpayer came to owe the unpaid tax if there is a somewhat tragic story behind the reason for the tax because I think this helps to put the offer examiner in the right frame of mind. In the absence of knowing how Mr. Gross came to owe this much in federal taxes, I enter the case less than sympathetic to his cause – not that it matters.
When someone owes $270,000 I expect that the IRS will go to the trouble to perfect its federal tax lien by filing a notice of that lien in the appropriate place. With this much money at stake and with so little effort needed to perfect the lien, I cannot understand how the IRS failed to file the notice of lien here. As with the underlying liability, I would like the decision to explain this to me. Courts generally would not know this type of information but this also influences my thinking about a case. If the IRS is so lazy or incompetent that it cannot file a notice in a case where the taxpayer owes $270,000, then I enter the case with less than sympathetic views about their cause. This is particularly true when you see that the IRS was carefully monitoring the bankruptcy case so that it could send the notice of levy at the first moment after the automatic stay was lifted. How could it get so excited about collecting a liability at that point after failing to take even the bare minimum of interest in collection prior to the bankruptcy petition?
So, I read this opinion wondering about lots of marginally relevant information and feeling no sympathy for either party. This case has another aspect that always troubled me when I worked for the IRS. Its policies make it difficult for revenue officers to go after retirement accounts. This bothers me because I think retirement accounts, or at least valuable retirement accounts, are owned by people of some means. The IRS will quickly go after very meager social security payments of individuals receiving $700 a month but requires its revenue officers to jump though bureaucratic hoops to go after a private pension. The pension here is described as having a value of $300,000 and being from the Director’s Guild of America.
Enough about what I want to know. The case presents a lesson in the power of the unfiled federal tax lien and in the distinction of assets passing through bankruptcy as exempt or excluded from the bankruptcy estate.
The federal tax lien arises when an assessment occurs followed by notice and demand and then refusal or neglect to pay. Although the opinions here do not detail how the federal tax lien came into existence, they do mention that Mr. Gross owed $270,000 in unpaid federal taxes for four years. It seems safe to assume that the IRS assessed the taxes, sent the appropriate notice and demand letters and Mr. Gross did not pay the taxes. Therefore, a federal tax lien existed. This lien is powerful even though it is secret since only the IRS and Mr. Gross knew of its existence. Many practitioners only think of the federal tax lien as coming into existence when notice of the lien is filed but notice merely perfects the lien against the parties listed in IRC 6323(a) and does not create the lien. So, the federal tax lien existed at the time Mr. Gross filed a chapter 7 bankruptcy petition on December 16, 2005.
The timing of the bankruptcy petition is important to the outcome of the case although not enough facts are described to allow more than the drawing of conclusions. In general, tax debts may be discharged if old enough. The general rule is debts for which the taxpayer timely filed a return become dischargeable once three years passes from the due date of the return for the year at issue. Here, the most recent of the years for which Mr. Gross owed taxes was 2001. The return for that year was due on April 15, 2002. That date was slightly more than three years before the date of the bankruptcy petition. Because everyone assumed the taxes were discharged, I assume the general rule was in play and not any of the exceptions. So, the taxes for all four years were discharged when the bankruptcy court entered the discharge order on June 2, 2006.
The discharge relieved Mr. Gross of personal liability for these taxes but it did not eliminate secured debt. To the extent that secured debt existed at the time of discharge, a creditor with such debt could look to the property securing the debt for payment even though it could not look to the individual. So, to the extent that the federal tax lien attached to property in existence at the time Mr. Gross filed bankruptcy and to the extent the bankruptcy did not sever the security, the IRS could seek to collect the outstanding liability from the property to which the lien attached. The leading case in support of this principle, as it relates to the federal tax lien, comes from the 9th Circuit and was cited by the Court. In re Isom, 901 F.2d 744 (9th Cir. 1990).
Things get tricky here because of bankruptcy law and what it can do to the federal tax lien. Absent the bankruptcy case, the federal tax lien clearly attached to Mr. Gross’ interest in the pension plan and to all of his other property and rights to property. The lien would have continued to attach to all of his property, rights to property and future acquired property until the underlying liability was extinguished – usually in the case of an unpaid liability the extinguishment of the liability would occur when the statute of limitations on the underlying liability expired. As Mr. Isom found out, extinguishing the in personam aspect of the liability through a bankruptcy discharge is not enough to extinguish the ability of the federal tax lien to attach to property.
Because the IRS had failed to file the notice of federal tax lien, the bankruptcy case put it at a distinct disadvantage. Bankruptcy Code section 545 places the trustee in the position of a bona fide purchaser for value. Such a purchaser is one of the parties that defeat the unfiled federal tax lien pursuant to IRC 6323(a). For that reason, the unfiled federal tax lien usually does the IRS little good in a bankruptcy case and allows the debtor to come out of bankruptcy free and clear of the lien. The trustee has the ability to bring an action to “avoid” (read: extinguish) the federal tax lien. The avoidance power of the trustee is squarely at issue here. In Wadleigh v. Commissioner, 134 T.C. 280 (2010) the Tax Court held that the bankruptcy trustee could not avoid the unfiled federal tax lien with respect to excluded property since such property was not a part of the bankruptcy estate. In Rains v. Flinn, 428 F.3d 893, 905-6 (9th Cir. 2005), the Ninth Circuit held that liens on prepetition assets that are not included in the bankruptcy estate are not affected by the bankruptcy proceeding.
The outcome of this case turns on the distinction between exempting property from the estate and excluding it. In setting up the bankruptcy system, Congress created a scheme of exemptions for debtors so that they would have some assets in their post-bankruptcy circumstances. The exemption provisions are found in Bankruptcy Code section 522. The Congressional scheme allows states to opt out of the federal system of exemptions which almost all states do and to set up their own exemption system. Some states are more generous than others. Although the opinion does not directly address the issue, I assume that California where Mr. Gross lived would have allowed him to exempt this pension. California, like most states with civil rather than common law roots, has very generous exemption provisions. If Mr. Gross had exempted the pension from his bankruptcy estate, the federal tax lien would have been extinguished because Bankruptcy Code section 522(c) provides that such property “is not liable during or after the case for any debt of the debtor that arose … before the commencement of the case, except [inter alia]…[a debt secured by] a tax lien, notice of which is properly filed [under IRC 6323].” Since no notice of federal tax lien was filed prior to the bankruptcy petition, if the pension had been exempted from the estate, the IRS would not have had the ability to collect from it after the bankruptcy case using its lien.
The Supreme Court , in Patterson v. Shumate, 504 U.S. 753 (1992) held that ERISA plans are excluded from bankruptcy estates pursuant to the language of Bankruptcy Code section 541(c)(2). In filing his bankruptcy schedules, Mr. Gross referred to the pension asset as an ERISA plan making it clear that he considered it excluded from the bankruptcy estate. Both the Tax Court and the Ninth Circuit agreed with his characterization of the asset as excluded. Consequently, the decisions in Wadleigh and Rains kicked in preventing the avoidance of the unfiled federal tax lien, allowing it to continue to attach and causing the courts to sustain the IRS levy upon the pension.
Excluding an asset from a bankruptcy estate is generally considered more favorable than exempting it since the exclusion allows the debtor to claim exemptions in other assets increasing the amount of the debtor’s post bankruptcy holdings. Here, the combination of the Supreme Court’s holding in Patterson excluding ERISA plans from bankruptcy estates with the decisions in Wadleigh and Rains holding that liens continue to exist on excluded property even though a lien such as the unfiled federal tax lien would have been extinguished had the property been exempted rather than excluded from the bankruptcy estate has the effect of making excluded property less desirable than exempted property. The pro-debtor decision in Patterson has now become a pro-creditor decision for the IRS. This outcome only benefits the IRS because ERISA does not allow other liens to reach assets in ERISA plans. The federal tax lien is the only lien with enough power to reach ERISA assets leading to this improbable result which demonstrates the power of the federal tax lien.
Occasional guest blogger with us, Lavar Taylor, wrote a brief in support of the position that the lien should not survive bankruptcy. In the brief he makes a number of arguments. If you seek a deeper understanding of the issue, I recommend Lavar’s brief even though it supports the position of the losing side. The result of this case may give pause to those headed into bankruptcy with both federal tax debt and pension assets. While the IRS generally moves slowly to enforce its rights in pensions, the bankruptcy case generally brings either Chief Counsel or Department of Justice lawyers, or both, into the case. They will more aggressively pursue pension assets in my opinion than most revenue officers.