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Priority of IRS Liens in Bankruptcy: Reminder That the King Gets Paid First

September 17, 2024

So starts the opinion of the United States Court of Appeals for the Ninth Circuit in United States v. MacKenzie:

“As Benjamin Franklin said, ‘nothing is certain except death and taxes.’ But how certain are taxes in a Chapter 7 bankruptcy? We address that question here, and we conclude that Mr. Franklin’s maxim withstands both time and the Bankruptcy Code (Code).”

The issue in MacKenzie, a Chapter 7 bankruptcy, was how to allocate the proceeds from the sale of the debtor’s real estate between the Internal Revenue Service (IRS), which had filed a valid lien against the real estate for taxes, interest, and penalties, and the bankruptcy estate. The sale proceeds were sufficient to satisfy the taxes, a portion of the interest, but none of the penalties. The bankruptcy court allocated the proceeds on a pro rata basis between the IRS and the bankruptcy estate. The district court affirmed, but the Ninth Circuit reversed and remanded, finding that pro rata allocation of the sales proceeds is inconsistent with the Code. [1]

Background

Code § 724(a) authorizes the trustee in a Chapter 7 bankruptcy to avoid a lien that secures a non-compensatory penalty, among certain other claims. Code § 726(a)(4). A lien for penalties is voidable, rather than void in Chapter 7. This allows for the lien to be revived if the case is converted to Chapter 11, under which non-compensatory penalty liens are not voidable. Code § 726 sets forth the order for distributing property in a Chapter 7 bankruptcy. Under Chapter 7, a lien for non-compensatory penalties is lower in priority than a lien for taxes and interest.

If a claim for penalties is avoided, it is automatically preserved for the benefit of the bankruptcy estate, and the trustee succeeds to the priority of the avoided interest. Code § 551. Thus, if the penalties secured by a tax lien are avoided, the penalties have a lower priority than the taxes and interest.

Code § 105(a) authorizes the bankruptcy court to issue any order, process, or judgment that is necessary or appropriate to carry out the provisions the Code.

As noted above, the bankruptcy court allocated the proceeds from the real estate sale on a pro rata basis between the IRS and the bankruptcy estate. By doing so, a portion of the proceeds were allocated to the avoidable penalties, even though the taxes and interest, which have a higher priority, were not fully satisfied by the sale proceeds. The IRS did not dispute that the Trustee could avoid the penalty portion of the lien, but argued that the proceeds should first pay the tax portion of the lien (the tax-first approach). The bankruptcy court concluded that the pro rata method “makes the most sense” because, in its view, the IRS and the bankruptcy estate share the same lien priority position following the avoidance under Code § 724 and the automatic preservation provision under Code § 551. The district court affirmed the bankruptcy court, but on appeal, the issue for the Ninth Circuit was whether the district court erroneously held that the bankruptcy court had the authority to adopt and apply the pro rata method under its general powers of Code § 105(a).

Discussion

The Ninth Circuit noted, as did the bankruptcy court and district court, that no Code provision expressly delineates who and how much is paid following partial avoidance of a tax lien under Code § 724(a) when there are insufficient funds to pay the lien. The absence of such express guidance in the Code did not give the Ninth Circuit much pause in finding that there was no support for the pro rata method in the Code. It found that Code § 105(a) does not allow the bankruptcy court to override explicit mandates of other sections of the Code or otherwise take action the Code prohibits. Compensatory tax portions of tax liens are unavoidable; a trustee’s ability to avoid IRS tax liens under Code § 724(a) is limited to non-compensatory penalty portions only.

Although Code § 551 preserves what Code § 724 avoids, the preservation in this case is limited to non-compensatory penalties. Thus, according to the Ninth Circuit, “a Trustee who avoids the penalty portion of a tax lien under § 724(a) preserves only the original lien’s priority position and the value of the penalty portion.” It found that the pro rata method is inconsistent with the Code in three significant ways.

• Applying the pro rata method, rather than the tax-first method, increases the amount that the Trustee avoids and preserves beyond what the text of Code §§ 724(a) and 551 allow. The sale proceeds should be first allocated to taxes and interest. As the proceeds were less than the sum of these amounts, no portion of the sale proceeds should be allocated to the bankrupt estate.

• Nothing in the Code justifies reducing the value of the unavoidable tax lien in the circumstances presented in the case. The authority granted by Code § 551 must be read in conjunction with Code § 724(a) and its express limitations.

• The pro rata method is at odds with priorities established in the Code. Code §§ 507, 725, and 726 establish that “[s]ecured creditors are highest on the priority list,” while “general unsecured creditors” are lower.

The pro rata method is based on the flawed premise that once a trustee avoids the penalty portion of a tax lien under Code § 724(a), the trustee and the IRS become equal claimants with equal rights to the entire tax lien. Not so, according to the Ninth Circuit. The Code treats liens and claims for taxes differently than those for penalties. Courts have recognized that the Code prioritizes the tax portion over the penalty portion.

The Ninth Circuit reversed the judgment of the district court with respect to the proper allocation method and remand with instructions to further remand to the bankruptcy court to determine the final allocation amount, consistent with its opinion.

[1] For a discussion of straddle-year tax debts in bankruptcy, see Podcast: Straddle-Year Tax Debts in Bankruptcy: Does the King Get Paid First?