To avoid forcing a debtor to pay the same tax lien twice, the majority on a Ninth Circuit panel held that a trustee may not avoid a lien securing a tax penalty and preserve the avoided lien for the estate, if the lien had attached to exempt property.
Although the tax lien would have been avoidable had it attached to nonexempt property under Section 724(a), the majority concluded that the lien could not be avoided as to exempt property under Section 726(a)(4) because the home was no longer estate property.
The dissenter saw the tax lien as avoidable and preservable because the entire home, including the exempt portion, was estate property on the filing date.
Warning: Reading this story and the opinions likely will cause brain cramps or narcolepsy.
Simple Facts
The debtor owned a home but did not file a return or pay taxes for 2015. The Internal Revenue Service assessed taxes plus penalties and interest. The debtor subsequently paid the taxes but not the penalties and interest.
The IRS recorded a tax lien to secure payment of the penalties.
Six weeks after the IRS filed the lien, the debtor filed a chapter 7 petition and claimed a homestead exemption of up to $150,000 under Arizona law. Her state opted out of federal exemptions. The exemption was allowed.
Based on the tax lien, the IRS filed a secured claim of almost $25,000.
The trustee moved to avoid the tax lien under Section 724(a) and preserve the lien for the estate under Section 551. The IRS and the debtor both objected, but the bankruptcy court avoided and preserved the lien. The district court affirmed.
While the appeal was pending in the Ninth Circuit, the debtor found a buyer for the home. The bankruptcy court approved the sale for $475,000, enough to pay off the mortgage. From the surplus after paying the mortgage and costs, the bankruptcy court directed the trustee to hold almost $27,000 to abide the outcome of the appeal. From the sale proceeds, the court gave the debtor some $30,000, representing the value of her homestead exemption from the net proceeds after setting aside the $27,000.
In other words, the entire equity in the home would have been exempt even if there were no tax lien.
The Majority Reverses
Sitting by designation and writing for the majority, District Judge Edward M. Chen of San Francisco reversed the lower courts, holding that the trustee could not avoid and preserve the lien.
Nonetheless, Judge Chen ruled in his November 18 opinion that the debtor took her exempt interest in the proceeds subject to the tax lien.
As a result, the IRS will be paid, but the debtor won’t pay twice.
Estate Property Evolves After Filing
The trustee moved to avoid the tax lien under Section 724(a) because it secured “a claim of a kind specified in section 726(a)(4).”
Section 726(a)(4) encompasses a secured or unsecured claim “for any fine, penalty, or forfeiture . . . to the extent that such fine, penalty, forfeiture, or damages are not compensation for actual pecuniary loss . . . .” Section 551 provides that a lien avoided under Section 724(a) “is preserved for the benefit of the estate but only with respect to property of the estate.” [Emphasis added.]
To reverse the lower courts, the majority also relied on the portion of Section 726(a) that says that “property of the estate shall be distributed . . . (4) fourth, in payment of any allowed claim, whether secured or unsecured, for any fine, penalty, or forfeiture . . . [that is] not compensation for actual pecuniary loss suffered . . . .” [Emphasis added.]
Everyone agreed that the tax lien fell within the definition of an avoidable lien under Section 724(a) but disagreed about whether the lien was avoidable.
True, the entire homestead became estate property on filing under Section 541(a), but Judge Chen said that property interests of the estate “evolve.” Specifically, he said that allowance of an exemption withdraws property from the estate and revests the property in the debtor.
Judge Chen went on to say that “§ 724(a) applies to property that is part of the estate at the time of distribution based on its express reference to § 726(a)(4).” For him, it was “clear from the express language of § 724(a) and its cross-reference to § 726(a)(4) . . . that § 724(a) concerns the trustee’s avoidance of qualifying liens attached to the property of the estate at the time of distribution.” [Emphasis in original.]
“When a debtor properly exempts a property interest under § 522,” Judge Chen said, “the exemption withdraws that property interest from the estate and, thus, from the reach of the trustee for distribution to creditors.” The exempted property, he said, revests in the debtor and is no longer property of the estate.
“[B]ecause exempt property is not ‘property of estate’ which may be ‘distributed,’” Judge Chen held that “a trustee may not avoid a lien under § 724(a) (that secures the kind of claim specified in § 726(a)(4)) attached to exempt property which is no longer part of the estate.” More plainly, he held that “§ 724(a) does not permit a trustee to avoid a tax lien secured by exempt property because such securing property is not property of the estate.”
Applying the holding to the facts, Judge Chen said that the debtor was entitled to exempt up to $150,000 from the net proceeds. “However,” he said, the debtor takes her exempt interest subject to the IRS’s tax lien under DeMarah v. United States, 188 B.R. 426, 431 (E.D. Cal. 1993), aff’d, 62 F.3d 1248 (9th Cir. 1995).
If the lien were avoided and preserved, Judge Chen said it would be “a troubling result” because the debtor would pay the same debt twice — first, by taking the $27,000 out of her exemption for the benefit of creditors, and second, because the lien would remain attached to the diminished proceeds that the debtor would receive from the sale. He said that the debtor’s “fresh start would hardly be served by doubling the burden of the previously existing tax lien on the debtor.”
“That the dissent’s interpretation of the statute produces such a perverse result provides powerful reason to reject that interpretation,” Judge Chen said.
The Dissent
Circuit Judge Patrick J. Bumatay “respectfully” dissented. He said that the majority’s desire to avoid a “troubling result” overrode the statute and nullified the trustee’s avoiding power.
Judge Bumatay said that “the answer here is simple: a trustee may avoid a federal tax lien and preserve it for the benefit of the estate.” The court should have “easily affirmed,” he said.
The majority’s notion about the evolution of the estate was “mistaken,” Judge Bumatay said. The Bankruptcy Code, as he reads it, says that property of the estate under Section 541(a) encompasses property “as of the commencement of the case.”
The homestead exemption, Judge Bumatay said, does not remove the entire homestead or tax lien from the estate. Citing Ninth Circuit precedent, he said that a debtor’s interest in property at the commencement of the case is property of the estate regardless of whether the debtor claims an exemption.
Addressing the majority concern about double payment, Judge Bumatay said that he could not “circumvent the plain text of the Bankruptcy Code.” He would have affirmed.
Observations
The following are the writer’s opinions:
Respectfully, Judge Bumatay misreads Section 541(a).
For the purposes of a chapter 7 case, the section defines estate property to include property owned by the debtor on the filing date to show that property acquired by the debtor after filing does not go into the estate. If property on the filing date, for example, were to remain estate property throughout, property sold during the case would remain estate property.
Similarly, the majority’s logic is questionable.
Respectfully, it is a stretch to say that Section 726(a) precludes a trustee from avoiding a lien on exempt property. The section serves other purposes.
To this writer’s way of thinking, the case is a perfect example of the fallacy in trying to divine an answer from statutory provisions designed to accomplish other objectives. Applying a statute to questions for which it was not intended can give an answer, but not necessarily the best answer.
In a case such as this, applying policy evident in the overall statute points in the right direction. As the dissenter appears to admit, allowing avoidance and preservation would have the debtor pay the same debt twice. Surely, that’s not what Congress intended. Indeed, it is clear to this writer that Congress did not contemplate the question that the appeals court was answering.
In a case like this, policy and common sense have a place in making decisions when the statute has no evident answer.
To avoid forcing a debtor to pay the same tax lien twice, the majority on a Ninth Circuit panel held that a trustee may not avoid a lien securing a tax penalty and preserve the avoided lien for the estate, if the lien had attached to exempt property.
Although the tax lien would have been avoidable had it attached to nonexempt property under Section 724(a), the majority concluded that the lien could not be avoided as to exempt property under Section 726(a)(4) because the home was no longer estate property.
The dissenter saw the tax lien as avoidable and preservable because the entire home, including the exempt portion, was estate property on the filing date.
Warning: Reading this story and the opinions likely will cause brain cramps or narcolepsy.