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Subordination of Tax Lien Denied

Posted on Nov. 12, 2021

In the bankruptcy case of In re Baldwin, 128 AFTR 2d 5762 (Bankr. N.D. Ohio 2021) the trustee’s attempt to use the subordination provisions of BC 724(b) fail because the bankruptcy court determines that selling the debtor’s house would not benefit the unsecured creditors of the estate and would harm the debtor’s wife who did not join in the bankruptcy petition.  Selling the house would have benefited the trustee and it would have benefited the IRS and a couple other secured creditors, but the job of the trustee is not to assist secured creditors but unsecured creditors.  The court provides an excellent analysis of the reason for its denial and a good worksheet showing where the dollars will go if the trustee prevailed.

The presence of a non-debtor, Mrs. Baldwin, who would lose her home in exchange for a relatively small amount of equity remaining after payment of the secured creditors, plays into the court’s decision as well, giving the opinion somewhat of the feel of a Rodgers’ analysis in addition to the 724(b) analysis.  In the 1983 case U.S. v. Rodgers, the Supreme Court said that while the government has broad discretion to force a sale, “Section 7403 does not require a district court to authorize a forced sale under absolutely all circumstances,” and it concluded that “some limited room is left in the statute for the exercise of reasoned discretion.” I have discussed the application of Rodgers in prior posts here and here.

Ohio has a pretty generous property exemption and Mr. Baldwin claimed an exemption of $220,000 in the property of the estate; most of that was in the jointly owned home.  We have discussed B.C. 522 and exemptions that debtors can claim in a bankruptcy case here and here.  Mr. Baldwin hopes in claiming this exemption that he would get to keep basically all of his property leaving his unsecured creditors empty handed while he received the benefit of a discharge.  I don’t say that because that’s a bad result but because it’s the common result of a no-asset chapter 7 case.  Because of the proposed outcome for unsecured creditors, the initial classification of this case was as a no-asset case since there were no assets available to pay claims of unsecured creditors.  The exemption claim does not impact the position of secured creditors.  It’s not clear that Mr. Baldwin understood that.

Mr. and Mrs. Baldwin had established the Baldwin Revocable Trust not too long before filing bankruptcy and transferred ownership of their home to this trust. The trustee in the bankruptcy argued that debtor didn’t have an ownership interest in the house where he lived because it was owned by the trust. Since he did not have an ownership interest, the trustee argued he could not exempt the property. The court sustained the trustee’s objection after which the trustee revoked the trust. The court notes that the bankruptcy trustee, standing in the shoes of the debtor, was entitled to revoke the trust in accordance with the trust agreement. I have trouble feeling sorry for Mr. Baldwin at this point because putting the property nominally in the name of the trust smacks of an effort to defraud creditors.

The trustee’s revocation vested a half interest in the property to the debtor and the trustee argued that the revocation made the property subject to the control of the bankruptcy estate, potentially turning the case into an asset case with funds available to at least partially satisfy unsecured creditors. The trustee then sought permission to sell the entire property. The debtor objected, arguing that the revocation vested 100% of the property in the hands of Mrs. Baldwin, who he argued was the sole grantor of the property to the trust. This reflects, in my view, another effort by Mr. Baldwin to defraud creditors. Despite the debtor’s attempted shenanigans, the court marches forward with a determination of the true property interest of the parties holding that trust. The court finds that H & W each own a half interest.

As mentioned above, this case was initially filed as a no-asset case. In no-asset cases, creditors are instructed not to bother filing a proof of claim since the claim will not matter. When the trustee revoked the trust and brought property into the estate, a notice went out to the creditors as happens when a case converts from no-asset to an asset case. The notice gave creditors six months to file a claim. Both the IRS and the Ohio taxing authority missed that deadline, which has negative consequences for general unsecured claims, but the court finds it has no negative consequences for secured creditors which both the IRS and Ohio were in this case.

As discussed in the earlier posts discussing the exemption provision in BC 522, the exemption does not exempt property where the taxing authority has perfected its interest by filing a notice of lien prior to the bankruptcy petition. Both the IRS and Ohio had perfected their lien interest prior to Mr. Baldwin’s bankruptcy petition, which meant he could not exempt the value of the property covered by these liens.

The trustee wants to use the bankruptcy not only to provide some payment to the unsecured creditors but also to the trustee. When the trustee finds assets, the trustee receives a percentage of those assets for their effort. This system incentivizes the trustee to look for assets and also benefits the unsecured creditors, who might receive nothing if the trustee did not pursue potential assets of the bankruptcy estate.

The court wants to assist the unsecured creditors but also has a broader responsibility. The court begins the discussion by signaling the trustee’s responsibilities to the estate as a whole:

“As a general rule, the bankruptcy court should not order property sold `free and clear of’ liens unless the court is satisfied that the sale proceeds will fully compensate secured lienholders and produce some equity for the benefit of the bankrupt’s estate.” In re Riverside Inv. P’ship, 674 F.2d 634, 640 (7th Cir. 1982) (emphasis added) (citing Hoehn v. McIntosh, 110 F.2d 199, 202 (6th Cir. 1940)).

A Chapter 7 trustee is responsible for liquidating the estate and using the proceeds to satisfy the debtor’s unsecured creditors. See generally 11 U.S.C. §§ 704 & 726. This power to liquidate property of the estate, however, “will not be exercised unless it is made to appear that there is a fair prospect of the property being sold for substantially more than enough to discharge the lien or liens upon it.” Hoehn v. McIntosh, 110 F.2d at 202. The Chapter 7 trustee, in other words, must generally abandon property that does not possess substantial equity. See In re Feinstein Family P’ship, 247 B.R. 502, 507 (Bankr. M.D. Fla. 2000).

The court does an excellent job of explaining why the sale here does not make sense, even going to the trouble of providing a detailed analysis of how the money will be divided between the bankrupt husband and his non-petitioning wife.  The outcome of not allowing the trustee to sell the property is arguably a windfall for the debtor but it is the right result.  Some of the secured creditors will undoubtedly get paid in the end.  This is a case where you might see the IRS bring a foreclosure suit to collect its taxes since the property has equity, and the taxpayers don’t seem inclined to pay otherwise.  Such a suit would, however, squarely mire the district court in the Rodgers factors since it would involve selling the house.

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