Marshaling and Subrogation Dealing with Unavoidable Tax Liens and Claims

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Apr 2003

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Taxing authorities have
the supreme advantage of having direct legislative support for the imposition
of taxes and the enforcement of liens to secure taxpayer obligations. There is ample
evidence of this in state statutory schemes, the Internal Revenue Code and even
the Bankruptcy Code. Thus, it is not surprising that statutory tax liens are
often automatic and broad.

A statutory tax lien may be a lien in solido. In other words, the lien may attach to all of a tax
debtor's property within the taxing authority's jurisdiction,
enabling a taxing authority to pick and choose which property to pursue. Under
such circumstances, there is no incentive for the taxing authority to pursue a
debtor's property subject to the lien on a pro rata basis, or to make any effort to calculate
proportionate shares of a debtor's tax obligation arising from specific
items of property. On the contrary, the most efficient course of action for a
taxing authority may well be to pursue a single item of property within the
scope of the lien of sufficient value to satisfy the tax obligation at once and
in full. Assuming such an item of property exists, chances are it is also
encumbered by prior perfected, but by operation of statute, inferior liens.

Thus,
a scenario may arise in which a creditor obtains an interest in a valuable item
of a tax debtor's property and takes all necessary steps to document,
record and timely perfect an interest in such property, but nonetheless finds
that the encumbered property is the target of a taxing authority's
efforts to satisfy the tax debtor's tax obligations.

Section 545(2) of the Bankruptcy Code provides a limited mechanism for challenging
statutory tax liens. Successful use of §545(2) may depend on a strict
application of the requirement that a "bona fide purchaser" be able
to prime the statutory lien in the relevant jurisdiction. See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Janssen, 213 B.R. 558 (8th Cir. B.A.P. 1997)</a>
(examining whether a §542(2) "bona fide purchaser" may avoid a
federal tax lien).

Assuming
that the status as a "bona fide purchaser" does not suffice to
avoid a tax lien pursuant to §545(2), or if a party is for other reasons
unable to avail itself of the lien avoidance provisions of the Bankruptcy Code,
what remedies remain? Marshaling may offer a party in interest an avenue of
approach to minimize or defeat the otherwise potentially significant
consequences of an unavoidable tax lien.

<h3>Marshaling</h3>

Marshaling
is an equitable doctrine that provides that a senior secured creditor with an
interest in a debtor's property may not gain satisfaction against such
property also encumbered by another secured creditor, if doing so would defeat
the second secured creditor's recovery, and if other property is
available to the first secured creditor to satisfy its claim. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3…
v. United States, 375 U.S. 233, 236, 84 S. Ct.
318, 11 L.Ed.2d. 293 (1963)</a>. Case law has distilled the doctrine
of marshaling to three essential elements: (1) two secured creditors with
claims against a common debtor, (2) the existence of two properties belonging
to the debtor and (3) the senior secured creditor, which has a right to either
of the properties, and the junior secured creditor, which has rights against
only one of the properties.<a href="#1" name="1a">1</a> See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Riverwood La Place Associates LLC, 234 B.R.
256, 259 (Bankr. E.D.N.Y. 1999)</a>; see, also, <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Vermont Toy Works Inc., 135 B.R. 762, 767
(D. Vt. 1991)</a> (stating that a proponent of marshaling must
establish the elements by clear and convincing evidence).

Marshaling
may not be applied if the senior secured creditor or other parties are unduly
prejudiced. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Pray, 242 B.R. 205, 209-10 (Bankr. D. Mass.
1999)</a>. Because the doctrine is designed to protect junior
secured creditors, the majority view is that unsecured creditors may not invoke
marshaling. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Craner, 110 B.R. 111, 123 (Bankr. N.D.N.Y.
1988)</a>. However, a trustee provided with the status of a secured
creditor by virtue of §544 of the Bankruptcy Code may move the court to
apply marshaling for the benefit of a debtor's estate. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re America's Hobby Center Inc., 223 B.R.
275, 287 (Bankr. S.D.N.Y. 1998)</a>. In <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Bame, 279 B.R. 833 (8th Cir. B.A.P. 2002)</a>,
the chapter 7 trustee invoked the marshaling doctrine against taxing authorities
to the substantial benefit of the estate's unsecured creditors.

In Bame, a debtor was faced with
unavoidable tax liens from the Internal Revenue Service (IRS) and the Minnesota
Department of Revenue. Approximately $1 million was available for distribution
to the estate's creditors. The taxing authorities held claims totaling
approximately $300,000. In addition to the taxing authorities' general
and sweeping liens against the debtor's estate, the taxing authorities
possessed liens, for the same tax obligations, against certain real property
owned by the debtor's non-debtor spouse. The estimated value of the real
property far exceeded the value of the taxing authorities' liens. The
chapter 7 trustee commenced an adversary proceeding against the taxing
authorities to compel marshaling to force the taxing authorities to attempt to
first satisfy their liens against the non-debtor spouse's real property
before receiving any distributions from the debtor's estate.

The
taxing authorities argued that the application of marshaling simply should not
be available against governmental agencies collecting revenue. Such a per se prohibition is the law in the Ninth Circuit, based
in part on a concern for the "considerable burden on the revenue
collection process." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Decker, 199 B.R. 684, 688 (9th Cir. B.A.P.
1996)</a> (quoting Kovaks v. United States, 355 F.2d 349, 351 (9th Cir.); cert.
denied, 384 U.S. 941, 86 S.Ct. 1460, 16
L.Ed.2d 539 (1966)). The Bame court declined to follow the Ninth Circuit rule, and stated that
"marshaling must be evaluated on a case-by-case basis, regardless of whether
a taxing authority is involved." <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; 279 B.R. at 838</a>.

The
taxing authorities next argued that they would be unacceptably prejudiced by
having to proceed against the non-debtor spouse's real property, largely
due to the potential costs and time delay attendant to any foreclosure process.
The bankruptcy court had determined that because the taxing authorities were so
vastly oversecured, these factors would not cause "undue harm" and
did not overcome the benefit to the estate's unsecured creditors that
would follow the proposed marshaling.<a href="#2" name="2a">2</a> The court also noted that in the
unlikely event that the taxing authorities would be unable to satisfy the tax
obligations from the non-debtor spouse's real property, the taxing
authorities would still have allowed claims against the debtor's estate.
The Bankruptcy Appellate Panel (BAP) for the Eighth Circuit agreed, and upheld
the application of marshaling to the claims of the taxing authorities.<a href="#3" name="3a">3</a>

Some
courts outside the Ninth Circuit have followed the absolute prohibition against
the application of marshaling against taxing authorities, especially if the
taxing authority is the United States. See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…
of America Bank West Michigan v. Alt, 848
F.Supp. 1343, 1351 (W.D. Mich. 1993)</a> ("there exists no
‘right of marshaling' against the United States") (quoting
United States v. Eshelman, 663 F.Supp. 285
(D. Del. 1987)). Courts adopting a more deliberative approach tend to focus on
the extent to which the senior secured creditor would be burdened by
marshaling, and the potential prejudice marshaling would impose upon other
parties.

<h3>Subrogation</h3>

Section 509 of the Bankruptcy Code provides: "Except as provided in subsection
(b) or (c) of this section, an entity that is liable with the debtor on, or
that has secured, a claim of a creditor against the debtor, and that pays such
claim, is subrogated to the rights of such creditor to the extent of such
payment." Subrogation has been characterized as an equitable doctrine,
and "one of the benevolences of the law" designed to provide for
the transfer of the rights of a first party to a second party who has paid the
obligations of a third party to the first party. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=7…
re Zoglman, 78 B.R. 213, 214 (Bankr. W.D. Wis.
1987)</a> (quoting 17 Am.
Jur. 2d Subrogation, §§1 and 7 (1974)).<a href="#4" name="4a">4</a> A co-debtor, guarantor or
similar third-party element must exist; a debtor may not invoke subrogation to
gain for itself the priority status of a governmental entity for the
obligations the debtor voluntarily pays. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re McCready, 255 B.R. 834, 836 (Bankr. M.D.
Tenn. 1999)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=7…
re Tygrett, 72 B.R. 129, 130 (C.D. Ill. 1987)</a>.

Although
§509 of the Bankruptcy Code arises from equitable principles, some courts
have stated that it remains a remedy distinct from nonstatutory equitable
subrogation. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
v. Cantor, 202 B.R. 573, 577-78 (D. Md. 1996)</a>;
<a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Spritos, 103 B.R. 240, 244 (Bankr. C.D. Cal.
1989)</a> (stating that Bankruptcy Code subrogation is an additional
non-exclusive remedy). Courts recognizing the distinction between statutory and
equitable subrogation note that traditional equitable subrogation requires that
the claim for which subrogation rights are asserted must be paid in full,
whereas §509 permits partial subrogation for partial payment of such a
claim.<a href="#5" name="5a">5</a> See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Northview Motors Inc., 202 B.R. 389, 401
(Bankr. W.D. Pa. 1996)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
U.S.C. §509(a)</a> (subrogee "subrogated to the rights of such
creditor to the extent of such
payment") (emphasis added).<a href="#6" name="6a">6</a> Both species of subrogation have been invoked
by debtors and other parties in interest seeking to limit the consequences of
unavoidable tax claims.

Section
509 of the Bankruptcy Code has been successfully utilized by parties who have
satisfied a debtor's tax obligations to challenge the dischargeability of
the debtor's tax obligations, as the taxing authority itself would have
been able to do pursuant to §523(a) of the <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=9…
Code. See In re Fields, 926 F.2d 501,
504 (5th Cir.), cert. denied, 502
U.S. 938, 112 S. Ct. 371, 116 L.Ed.2d 323 (1991)</a>; <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=3…
re Alloway, 37 B.R. 420, 423 (Bankr. E.D. Pa.
1984)</a> ("[One] who has paid the tax liability of another,
subject to the limitations of §509(a), may be subrogated to the claim of
the taxing authority and may thus seek an exception to discharge based upon
that claim.").<a href="#7" name="7a">7</a>

A
pair of late Bankruptcy Act cases held that equitable subrogation may be
invoked by parties who satisfy tax obligations owed to the United
States. In <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2… re Co-Build Companies Inc., 21 B.R 635 (Bankr. E.D. Pa. 1982)</a>, the bankruptcy court permitted an
officer of a debtor corporation to assert the priority claim of the IRS against
the debtor after the government had intercepted the officer's tax refund
to satisfy the debtor's tax obligations. In <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=5…
re Metropolitan Metals Inc., 50 B.R. 685
(Bankr. M.D. Pa. 1985)</a>, the IRS had instituted a levy against a
debtor's accounts receivable from a third party who owed a substantial
amount to the IRS. The trustee in the case requested that the bankruptcy court
apply marshaling to compel the United States to pursue the non-debtor's
property to attempt to satisfy the tax obligation before obtaining a
distribution from the bankrupt debtor's estate. The court declined to
order marshaling because the property at issue—the receivable—was
not owned by a common debtor, as required for the application of equitable
marshaling. In large part because of the prejudice to the estate's
creditors that would result from the United States's acquisition of the
receivable, the bankruptcy court concluded that the debtor, "as one who
has been compelled to pay the debt of another," was entitled to step into
the shoes of the IRS and exercise all rights and remedies the IRS had against
the non-debtor third party primarily liable for the tax obligation. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=5…; at 698</a>.<a href="#8" name="8a">8</a>

<h3>Conclusion</h3>

The
determination that a tax claim or lien is unavoidable does not necessarily mean
that the negative consequences of such a claim or lien are entirely
unavoidable. Two remedies based in equity, marshaling and subrogation may offer
some relief to a party who is forced to satisfy tax obligations on behalf of
another.

<hr>
<h3>Footnotes</h3>

<a name="1">1</a> The
right to marshal is a property right derived from state law. See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re High Strength Steel Inc., 269 B.R. 560, 572
(Bankr. D. Del. 2001)</a>. <a href="#1a">Return to article</a>

<a name="2">2</a> The
bankruptcy court's decision is reported in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re Bame, 271 B.R. 354 (Bankr. D. Minn. 2001)</a>. <a href="#2a">Return to article</a>

<a name="3">3</a> Because
there was technically no "common debtor," the Bame court based its decision, in part, on more equitable
considerations as permitted by case law developed in the <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
Circuit. In re Bame, 271 B.R. 354, 361-62 (Bankr. D. Minn. 2001)</a>.
Some courts have dispensed with the "common debtor" requirement
entirely in certain circumstances involving inequitable conduct or alter-ego
theories. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Borges, 184 B.R. 874, 879 & n. 3 (Bankr.
D. Conn. 1995)</a> (citing cases). <a href="#3a">Return to article</a>

<a name="4">4</a> Subrogation
may not be available to those who pay the obligations of another as a
"volunteer." See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=1…
re Fischer, 184 B.R. 41, 43 (Bankr. M.D. Tenn.
1995)</a>; cf. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=7…
re Zogleman, 78 B.R. 213, 215 (Bankr. W.D. Wis.
1987)</a> ("Persons who have an interest of their own to
protect by making payment are not volunteers."). <a href="#4a">Return to article</a>

<a name="5">5</a> Note
that §509(c) of the Bankruptcy Code provides that a subrogated claim is
subordinated until the claimant is paid in full. <a href="#5a">Return to article</a>

<a name="6">6</a> Other
courts have examined the considerations of both statutory and equitable
subrogation simultaneously in reaching a result. See, e.g., <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=7…
re Zogleman, 78 B.R. 213, 214-15 (Bankr. W.D.
Wis. 1987)</a>. <a href="#6a">Return to article</a>

<a name="7">7</a> Note
that §507(d) of the Bankruptcy Code limits the rights of subrogees to
assert priority claims based on subrogation, but such limitation does not
affect a party's right to utilize subrogation to object to the
dischargeability of a debt. See <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=8…
re Cooper, 83 B.R. 544, 547 (Bankr. C.D. Ill.
1988)</a>. <a href="#7a">Return to article</a>

<a name="8">8</a> More
recently, in <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…
re White Trailer Corp., 266 B.R. 390 (Bankr.
N.D. Ind. 2000)</a>, the trustee sought, pursuant to §510(c) of
the Bankruptcy Code, to equitably subordinate the sales tax claims of the IRS
because the IRS could have sought payment for such taxes against another entity
and did not do so. The court declined to subordinate the claims of the IRS, but
suggested that the debtor could have subrogated to the rights of the IRS had it
paid the tax claims instead. <a href="http://www.westlaw.com/find/default.wl?rs=CLWD3.0&vr=2.0&cite=2…; at 394</a>. <a href="#8a">Return to article</a>

Journal Authors

Marvin E. Sprouse

Journal Date

Tuesday, April 1, 2003 - 12:00

Bankruptcy Rule

2003