The Bankruptcy Code permits a trustee to avoid a tax lien to the extent the lien secures a tax penalty. The Code then “preserves” the avoided lien for the benefit of the bankrupt estate.

Although the avoided lien is preserved for the benefit of unsecured creditors, the Ninth Circuit decided that the avoided lien is worthless when the collateral is worth less than the tax portion of the lien that was not avoided.

In her September 3 opinion, Circuit Judge Ana de Alba explained the result by saying that “claims for tax portions of IRS liens receive a higher priority than claims for penalty portions.”

The Tax Lien

The Internal Revenue Service had a recorded tax lien for about $70,000. The lien was for some $45,000 in taxes and $25,000 in penalties. Collateral for the lien was real property that the chapter 7 trustee sold for less than $40,000.

Under Sections 724(a) and 726(a)(4), the trustee avoided the penalty portion of the tax lien. Section 551 provided that the avoided penalty lien was automatically “preserved for the benefit of the estate . . . .”

The value of the collateral was not enough to pay both the tax and the penalty. For the bankruptcy court, the question was how to allocate the $40,000 between the valid tax lien for $45,000 and the avoided, but preserved, penalty lien for $25,000.

From the entire $70,000 tax lien, about 65% was for taxes and 35% was for penalties.

The bankruptcy court decided on a pro rata split, giving the IRS about $26,000, or 55%, while turning over some $14,000, or 45%, to the trustee. The IRS appealed but lost in district court. For the IRS, the appellate section of the tax division of the Department of Justice appealed to the Ninth Circuit. The DOJ won.

The Purpose of Preservation

Judge de Alba said that the outcome turned on an “interplay” among “several Code provisions in chapter 7.” In contrast with the former Bankruptcy Act, she said that avoided liens for tax penalties are now avoidable and not void per se. She explained that the change was made for chapter 7 cases converted to chapter 11, where the lien for a penalty is not avoided.

Section 726(a) lays out the priorities, while Section 551 “works in tandem” with avoidance under Section 724(a), Judge de Alba said. She explained that the automatic preservation of avoided liens was designed to prevent junior lienholders by profiting from avoidance.

Judge de Alba said that Section 551 is “limited in scope” and “preserves only . . . noncompensatory penalties.” Thus, she said that a trustee “preserves only the original lien’s priority position and the value of the penalty portion.”

Judge de Alba said that the pro rata distribution was “inconsistent” with the Bankruptcy Code in three ways. First, she said that it diminished the value of the unavoidable tax lien but “also avoids and preserves part of the unavoidable portion of the tax lien for the Estate.”

Second, Judge de Alba found “nothing” in the Bankruptcy Code that “justifies reducing the value of the unavoidable tax lien.” Third, she said that pro rata distribution would be “at odds with priorities established in the Code,” where secured creditors enjoy the highest priority. Because the Bankruptcy Code “prioritizes taxes over penalties,” she said, “it follows that the secured portion of the IRS lien should go to the tax portion before the penalty portion.”

In other words, “the pro rata method reduces the amount that the IRS receives for its secured, unavoidable tax portion of the lien to pay other unsecured creditors, who are lower in priority and had no rights to the IRS lien at all,” Judge de Alba said.

Preservation Doesn’t Ensure a Remedy

The trustee had argued that the estate and the IRS had equal rights after the penalty lien was avoided but preserved. Judge de Alba responded by saying that the former Bankruptcy Act and the Bankruptcy Code “disfavor recovery for penalties in bankruptcy.” She said that the Bankruptcy Code “makes clear” that claims for tax portions of IRS liens “receiver a higher priority than claims for penalty portions.”

Although the trustee steps into the shoes of the holder of the avoided lien, Judge de Alba identified “no provision [that] requires or guarantees that the Estate ultimately receive[s] payment for avoided penalty portions of a tax lien when the property is over-encumbered.”

“In short,” Judge de Alba said, “the pro rata” method is inconsistent with existing caselaw and the present Code’s text and history. She reversed and remanded for the bankruptcy court to work out the final allocation.

Observations

The result is the same as though the trustee had never avoided the penalty lien. The decision could be seen as reading out the provisions of the Bankruptcy Code that preserve avoided liens for the benefit of the estate. If preservation is the relief afforded to trustees by statute for avoiding liens, how can a trustee be deprived of the remedy?

However, putting the trustee ahead of lienholders junior to the avoided lien is not the same as allowing a trustee to chip away at an otherwise valid and enforceable lien. As Judge de Alba said, the result comports with rules about priority of distribution.