A trustee can avoid a lien for a tax penalty. It stands to reason, does it not, that a debtor can avoid the same lien but preserve the lien for the debtor’s benefit, to the extent the lien impairs the homestead exemption?
Answer: No. On a homestead, a trustee can avoid a tax-penalty lien for the benefit of the estate, but a debtor cannot avoid and preserve the same lien for the debtor’s benefit, according to the Ninth Circuit.
Warning: This story will make your head hurt.
The Internal Revenue Service had recorded liens on the debtor’s homestead to secure a claim for $162,000 in tax penalties. Years later, the debtor filed a chapter 7 petition.
The debtor filed a complaint against the IRS, claiming that the lien for a penalty was the type of lien in Section 726(a)(4) that a trustee can avoid under Section 724(a). Because the trustee by that time had not moved to avoid the lien, the debtor alleged that he could avoid the lien under Section 522(h) for his benefit to the extent of his $100,000 state homestead exemption.
Sounds open and shut in the debtor’s favor. But it’s not, according to an amended opinion on December 23 by Circuit Judge Daniel P. Collins.
The trustee answered and filed a cross claim, asserting his right to avoid the lien and preserve the lien for the estate. The IRS filed a motion to dismiss the debtor’s complaint.
The IRS agreed that the trustee could avoid and preserve the lien to the extent it secured penalties. The bankruptcy court granted the IRS’s motion to dismiss the debtor’s complaint, and the Bankruptcy Appellate Panel affirmed.
On the debtor’s second appeal, Judge Collins said that the debtor could avoid the tax-penalty lien under Section 522(h) “in theory.” Unfortunately for the debtor, the Ninth Circuit had already debunked the theory in DeMarah v. United States (In re DeMarah), 62 F.3d 1248, 1250 (9th Cir. 1995).
The debtor’s problem is found in Section 522(c)(2)(B). The section says that exempt property is not liable for a debt, “except . . . a debt secured by a lien that is . . . a tax lien, notice of which is properly filed.”
In DeMarah, the Ninth Circuit said it was logical for Congress to allow a trustee to avoid a lien for the benefit of unsecured creditors but not to benefit a debtor who had incurred tax penalties.
Judge Collins held that Section 522(c)(2)(B) therefore barred the debtor from avoiding the tax lien, even though it was avoidable by the trustee under Section 724(a).
Judge Collins described a second reason why the debtor’s theory failed: The trustee had avoided the lien by stipulation with the IRS, and Section 522(h)(2) only allows a debtor to avoid a transfer if the trustee has not attempted to avoid the transfer.
Not deterred, the debtor had a fallback. Even though the tax lien was avoidable by the trustee, the debtor argued that he was entitled to preserve the lien for himself.
The debtor contended that preservation of the avoided lien for the benefit of the estate was overridden by Section 522(i)(2), which says that a transfer avoided under Section 724(a) “may be preserved for the benefit of the debtor to the extent the debtor may exempt such property . . . .”
The argument failed under DeMarah, Judge Collins said, because “that provision is equally subordinate to § 522(c)(2)(B)’s bright-line rule that debtors lack ‘the right to remove tax liens from their otherwise exempt property.’” DeMarah, supra, at 1252.
Judge Collins saw “no principled basis on which to reach a different conclusion when § 522(g)’s exemption authority is instead incorporated into § 522(i)(2).”
Judge Collins summed up the holdings as follows:
Indeed, the text of § 522(c)(2)(B) makes quite clear that its rule that debtors cannot use exemption authority to escape tax liens applies even if (as here) the tax liens are otherwise avoided by a trustee under § 724(a) . . . . Because § 522(c)(2) thus makes clear that a debtor’s exemption power cannot escape a tax lien, regardless of whether that lien was avoided by the trustee, it would be completely contradictory to then construe § 522(i)(2) (or § 522(g), for that matter) as allowing a debtor, after a trustee has avoided the tax lien, to then preserve the avoided lien “for the benefit of the debtor” by claiming an exemption under § 522(g).
A trustee can avoid a lien for a tax penalty. It stands to reason, does it not, that a debtor can avoid the same lien but preserve the lien for the debtor’s benefit, to the extent the lien impairs the homestead exemption?
Answer: No. On a homestead, a trustee can avoid a tax-penalty lien for the benefit of the estate, but a debtor cannot avoid and preserve the same lien for the debtor’s benefit, according to the Ninth Circuit.